Free Reply Memorandum - District Court of California - California

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 1 of 20

1 2 3 4 5 6 7 8 9 10 11

KEKER & VAN NEST, LLP MICHAEL D. CELIO - #197998 CLEMENT S. ROBERTS - #209203 JO F. WEINGARTEN - #246224 710 Sansome Street San Francisco, CA 94111-1704 Telephone: (415) 391-5400 Facsimile: (415) 397-7188 Email: [email protected] [email protected] [email protected] Attorneys for Defendants ALEXANDER JAMES TRABULSE, FAHEY FUND, L.P., FAHEY FINANCIAL GROUP, INC., INTERNATIONAL TRADE & DATA, and ITD TRADING

UNITED STATES DISTRICT COURT 12 NORTHERN DISTRICT OF CALIFORNIA 13 SAN FRANCISCO DIVISION 14 15 SECURITIES AND EXCHANGE COMMISSION, Case No. C-07-4975 WHA 16 Plaintiff, 17 v. 18 ALEXANDER JAMES TRABULSE, 19 Defendant, 20 and 21 22 23 Relief Defendants. 24 25 26 27 28 FAHEY FUND, L.P., FAHEY FINANCIAL GROUP, INC., INTERNATIONAL TRADE & DATA, and ITD TRADING, Date Action Filed: September 26, 2007 Date: December 6, 2007 Time: 8:00 a.m. Courtroom: 9 Judge: Hon. William H. Alsup DEFENDANTS' REPLY IN SUPPORT OF THEIR MOTION TO DISMISS

406672.05

DEFENDANTS' REPLY ISO MOTION TO DISMISS. CASE NO. C-07-4975 WHA

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 2 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

I.

Introduction

The SEC's opposition to the defendants' motion to dismiss cannot save the complaint. Much of the opposition is devoted to repeating (and occasionally supplementing) the complaint's allegations with greater emphasis and added invective. But fervent protestations cannot substitute for compliance with the demands of Rule 9(b). There are two basic flaws in the SEC's complaint that its opposition does not address and cannot cure. First, the opposition neither addresses nor ameliorates the complaint's lack of specificity. For example, while the complaint generally accuses Mr. Trabulse of affirmatively misleading investors about the kind of assets in which the Fund would invest, the complaint never identifies a specific statement or names any individual to whom such a statement was supposedly made. If the complaint contained such a statement, the SEC would simply have pointed to the paragraph in which it was set forth. But because the SEC cannot do that--because no such paragraph exists--it instead attempts to morph its allegations that Mr. Trabulse made affirmative misstatements about the scope of the Fund's investments into allegations that Mr. Trabulse omitted information about that scope. But even for an "omission" claim the law requires that the SEC identify a specific affirmative statement that is rendered misleading as a result of the omission. To put it another way, an omission claim is actually harder to plead because it requires particularized allegations of two facts rather than just one: the identification of a particular statement and the omitted information that makes the statement misleading. As a matter of logic, the SEC's failure to identify a particular misleading statement necessarily implies that it has also failed to plead a cognizable omission. Second, and perhaps more importantly, the complaint's legal theories are often illogical and internally inconsistent. For example, the SEC alleges that the Fund's quarterly reports were misleading because, when aggregated, they show a balance in excess of the contemporaneous balances in the Fund's bank and brokerage accounts. But as the defense has pointed out repeatedly, the SEC simply ignores the Fund's other assets--the very assets that the SEC claims the Fund failed to adequately disclose in those same reports. The SEC cannot have it both ways: either those assets are material--in which case the SEC may not simply ignore them--or the 1
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 3 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

assets are not material, in which case the SEC cannot claim that the Fund's alleged failure to disclose its investment in those assets is a material omission. Nor, as discussed in the opening motion and below, is this the only place where the SEC's pleadings simply fail as a matter of logic. Because the defense cannot be expected to answer a complaint with contradictory and nonsensical factual allegations, the complaint does not meet the requirements of Rule 9(b), and the SEC should be required to replead. II. A. Argument

The SEC's first and second causes of action must be dismissed. The SEC's first and second claims for relief each require the SEC to plead the same

elements: "(1) a material misstatement or omission (2) in connection with the offer or sale of a security (3) by means of interstate commerce." SEC v. Phan, 500 F.3d 895, 907-08 (9th Cir. 2007) (internal quotations omitted).1 As discussed below in more detail, nothing in the SEC's opposition can change the fact that the SEC has failed to satisfy its obligations under Federal Rule of Civil Procedure 9(b) with respect to both of the first two elements. 1. The SEC has not alleged specific misstatements or omissions, nor has it offered a factual basis to allege falsity.

The SEC's attempts to satisfy the requirements of pleading "a material misstatement or 17 omission" by pointing to allegations in the complaint: (a) that the Fund's quarterly reports 18 overstated the value of the fund; (b) that Trabulse made false statements to investors about the 19 kind of assets in which the Fund would invest; and (c) that the quarterly reports omitted 20 21 Defendants' Motion to Dismiss ("Opp.") at 11-12. As discussed below, the SEC has not met the 22 requirements of Rule 9(b) with respect to any of these allegations. 23 24 25 26 27 28 For reference, the first and second causes of action allege violations of Section 17(a) of the Securities Act [15 U.S.C. §77q(a)]; Section 10(b) of the Exchange Act [15 U.S.C. §78j(b)]; and Rule 10b-5 [17 C.F.R. § 240.10b-5]. See Complaint ("Complt.") ¶¶ 38-43. 2 The SEC also claims that "[t]he Complaint further alleges that the statements were false because they ... hid Trabulse's misappropriation of investor money," but the SEC offers no supporting citation and, in fact, the complaint contains no such allegation. Opp. at 12. In any event, even if it did contain such an allegation, as discussed in section II B, the SEC has no factual basis to assert, and therefore has not specifically alleged, that Trabulse misappropriated investor assets. 2
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA
1

information about the kind of assets in which the Fund invested.2 See Plaintiff's Opposition to

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 4 of 20

1 2

a.

The SEC has not identified specific statements in the quarterly reports.

The complaint fails to identify a specific statement in the quarterly reports or the 3 accompanying newsletters that is alleged to be false. The SEC argues, instead, that it has done 4 enough in alleging that the quarterly reports "bore no relationship to reality" and complains that 5 it is not required to plead "every detail of every account statement sent to 100 separate investors 6 at the end of each calendar quarter over a span of several years." Opp. at 11, n.7. Both of these 7 arguments are misplaced. 8 The defense agrees that the SEC need not plead every detail of the account statements. 9 But nothing about this proposition changes the fact that the SEC is required to identify the 10 specific statements alleged to be false. See Kaplan v. Rose, 49 F.3d 1363, 1370 (9th Cir. 1994) 11 ("The pleadings must state precisely the time, place, and nature of the misleading statements, 12 misrepresentations, and specific acts of fraud."); Moore v. Brewster, 96 F.3d 1240, 1245 (9th 13 Cir. 1996) (dismissing under Rule 9(b) where plaintiff "failed to identify any specific 14 statements.") cert. denied, 516 U.S. 810 (1995). So, while the SEC need not plead every detail 15 of the allegedly false statements, it has to plead enough to identify the specific statement alleged 16 to be misleading. The SEC cannot simply point to the entirety of the quarterly reports and the 17 18 (unidentified) statements in those documents are false when aggregated in some (unspecified) 19 manner. See SEC v. Baxter, 2007 WL 2013958, at *3 (N.D. Cal. Jul. 11, 2007) ("`[A] plaintiff 20 must set forth more than the neutral facts necessary to identify the transaction.'") (quoting Vess 21 v. Ciba-Geigy Corp., 317 F.3d 1097, 1106 (9th Cir. 2003)). 22 Moreover, the SEC's argument relies on a false dichotomy. There is a huge gap between 23 pointing generally at eight years of quarterly reports and reciting "every detail" therein. While 24 the SEC need not do the latter, it cannot simply do the former because it makes it impossible for 25 the defense to intelligently respond to the complaint. To illustrate the point, consider that--on 26 27 28 The SEC is explicitly attempting to rely on unidentified statements in the newsletters. See Opp. at 12 ("At its core, the Complaint alleges that, from 1998 through 2006, the account statements and newsletters sent to investors at the end of each quarter were false.") (emphasis added). 3
406672.05 3

accompanying newsletters--over a period of more than eight years3--and assert that

DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 5 of 20

1 2 3 4 5 6 7 8 9

the current record--the defense has no idea: (1) whether the SEC believes the quarterly reports are wrong with respect to every investor or just with respect to some investors; (2) which of the dozens of numbers are contended to be inaccurate and in which quarterly reports; and (3) which statements in the newsletters are alleged to be false. Neither the complaint nor the SEC's opposition even purports to answer these questions and, therefore, thwarts the purpose of Rule 9(b). See Semegen v. Weidner, 780 F.2d 727, 731 (9th Cir. 1985) ("Rule 9(b) ensures that allegations of fraud are specific enough ... so that [defendants] can defend against the charge and not just deny that they have done anything wrong."). b. The SEC has not alleged (and does not have) a basis for asserting that the quarterly reports overstated the Fund's value.

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Insofar as the Court finds that the SEC has made allegations regarding specific numbers and/or statements in the quarterly reports, the SEC has nonetheless failed to say why and how it contends those numbers and/or statements are inaccurate. The law is clear that the SEC cannot simply allege that a particular statement is wrong (or, more colorfully, that it "bears no relation to reality"), but must instead "set forth what is false or misleading about a statement, and why it is false. In other words, the plaintiff must set forth an explanation as to why the statement or omission complained of was false or misleading." In re GlenFed, Inc. Sec. Litig., 42 F.3d 1541, 1548 (9th Cir. 1994).4 But the SEC's proffered explanation of why and how the quarterly reports overstated the Fund's value is wrong is both illogical and internally inconsistent. The SEC keeps trying to compare statements in the quarterly reports that supposedly show the overall value of the Fund with the value of the bank and brokerage accounts that make up one part of the Fund. See Opp. at 11:3-6. This is precisely the kind of non-sensical explanation that the Court should not accept, Contrary to the SEC's assertion that Mr. Trabulse relied upon "cases addressing the requirements for a private plaintiff under the Private Securities Litigation Reform Act ("PSLRA") [15 U.S.C. § 78u-4 et seq.]," in support of the motion's Rule 9(b) arguments, In re GlenFed and the other cases relied upon in the defendants' motion do not consider or apply the PSLRA. See Opp. at 8 n.4. In fact, In re GlenFed was decided prior to the 1995 passage of the PSLRA, as were other cases upon which the defendants relied. See Motion at 5 (citing Neubronner v. Milken, 6 F.3d 666, 671 (9th Cir. 1993)). The motion also relied upon SEC cases which applied the pleading requirements of Rule 9(b) to the SEC. See id. (citing, for example, 4
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA
4

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 6 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

even on a motion to dismiss. See SEC v. Yuen, 221 F.R.D. 631, 634 (C.D. Cal. 2004). Perhaps because it is unable to explain away this problem, the SEC argues, instead, that it need not take the value of the Fund's non-securities investments into account because "the account statements omit any reference to such `investments.'" Opp. at 11-12. But this is mixing apples and oranges. Nothing about the defendants' alleged failure to identify the Fund's nonsecurities assets has any bearing on whether the quarterly statements affirmatively misrepresented the value of the Fund. The two questions--first, was the value of the Fund as advertised; and, second, were the defendants obligated to provide more information about the identity of the assets that made up the Fund--are logically distinct. Nothing about the answer to the former question turns on the answer to the latter. And absolutely nothing (in the latter question or otherwise) relieves the SEC of its obligation to plead a factual basis for asserting that quarterly reports misrepresented the value of the Fund. The SEC's failure to allege (or even develop) a factual basis for saying that the quarterly reports overstated the value of the Fund is fatal under Rule 9(b) because, again, Ninth Circuit "cases have consistently required that circumstances indicating falseness be set forth" in the complaint. In re GlenFed, Inc. Sec. Litig., 42 F.3d at 1548. c. The SEC has not identified any allegedly false statements to investors about the kind of assets in which the Fund would invest.

18 19 20 21 22 23 24 25 26 27 28

The SEC's complaint also fails to identify any specific statements that Mr. Trabulse allegedly made regarding the kinds of assets in which the Fund would invest. In particular, the complaint identifies no specific statements, no persons to whom such a statements was purportedly made, and no time, place, or circumstances surrounding any such statement. Indeed, the complaint is so devoid of specifics on this point that the SEC's opposition does not even try to defend this theory. Instead, the SEC's opposition hangs its hat on the "omission" version of this argument--namely that the defendants misled the Fund's investors by failing to list each of the Fund's non-securitized assets in the quarterly reports. As discussed below, however, the SEC has not adequately alleged such an omission. SEC v. Yuen, 221 F.R.D. 631 (C.D. Cal. 2004)).

5

406672.05

DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 7 of 20

1 2

d.

The SEC has not adequately alleged the quarterly reports omitted information about the kind of assets in which the Fund invested.

In response to the arguments set forth above, the SEC contends that even if it has failed to 3 make out a misrepresentation claim, it has still adequately claimed that the Fund omitted material 4 information from its investors. The problem with the SEC's attempt to make out an omissions 5 case is that the standard for pleading an omission is more stringent. To state a 10b-5 claim, 6 plaintiffs must allege defendants made an untrue statement of a material fact, or omitted to state 7 a material fact necessary in order to make the statements made, in light of the circumstances in 8 which they were made, not misleading. See, In re Read-Rite Corp., 335 F.3d 843, 846 (9th Cir. 9 2003); see also Rule 10b-5(b) (making it unlawful "to omit to state a material fact necessary in 10 order to make the statements made, in the light of the circumstances under which they were 11 made, not misleading"); 15 U.S.C. § 77q(a) (Section 17(a)(2) of the Securities Act) (same). 12 Thus, even where the SEC intends to rely on an alleged "omission," it must nonetheless identify 13 a specific "statement made" that was allegedly rendered misleading by the specifically alleged 14 omission. 15 But the SEC has utterly failed to identify any statements that were purportedly rendered 16 misleading by what it now contends are Trabulse's "omissions." Indeed, there are only three 17 paragraphs in the complaint that might be said to deal with the issue--Paragraphs 28, 29 and 18 30--which are gathered under the title "Trabulse Failed to Disclose How He Used Investor 19 Money." See Compl. ¶¶ 28, 29, 30. But, none of those paragraphs are sufficient to satisfy the 20 dictates of Rule 9(b). 21 Paragraph 28 is entirely about (unspecified) affirmative misrepresentations--not about 22 any purported omission. See id. ¶ 28. And, as affirmative statements, the allegations in this 23 paragraph are patently insufficient--indeed they do not identify any specific statement, any 24 person to whom such a statement was made, and/or the date time and circumstances of any such 25 statements. For this reason, the allegations in this paragraph do not form a basis for either a 26 affirmative misrepresentation case or provide a specific "statement made" that could form the 27 basis of an allegation of misrepresentation by omission. 28 6
406672.05

DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 8 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Paragraph 29 is about purported omissions--but all it says is that the defendants "failed to tell investors before they invested money that the Fahey Fund invested or planned to invest in, such illiquid items . . . [and] fail[ed] to identify them in account statements or elsewhere." Id. ¶ 29. Once again, this paragraph is insufficient because nothing therein identifies a specific "statement made" that could have been rendered misleading by an alleged omission. Paragraph 30 does no better--alleging only that "Trabulse did not inform investors that he used investor funds to purchase jewelry and rugs for his family." Id. ¶ 30. Again, this allegation does not identify an affirmative statement that was supposedly rendered false or misleading by virtue of the alleged omission. Nor could it, because Mr. Trabulse had no obligation to tell investors how he spent the portion of the Fund's profits that comprised his compensation. See SEC v. Rauscher Pierce Refsnes, Inc., 17 F. Supp. 2d 985, 991-92 (D. Ariz. 1998) ("For [the SEC] to succeed in proving an omissions claim . . . [the SEC] must also establish that Defendants had an affirmative duty to disclose the disputed information. . . . Even if the information that was not disclosed is deemed to be material, `there is no liability under Rule 10b-5 unless there is a duty to disclose it.'") (quoting Glazer v. Formica Corp., 964 F.2d 149, 156 (2d Cir. 1992)). Indeed, it is precisely to prevent plaintiffs from making this kind of illfounded allegations about generalized omissions that the law requires them to tie the alleged omission to an affirmative statement that was allegedly rendered misleading. The fact that the SEC has not even attempted to do so, is fatal to its claim under Rule 9(b). The Court also should note that, in advancing its "omission" argument, the SEC is advancing two mutually inconsistent factual positions. Either the amount of money the Fund invested in "other" assets is material or it is not. If it is, the SEC cannot reasonably compare statements about the total value of the Fund with the bank and brokerage records, which only represent a portion of the Fund's value. If, on the other hand, the amount invested in nonsecurities assets is not material, than the SEC cannot allege that failing to identify these investments constitutes a material omission. The fact that the SEC cannot make up its mind about which of these mutually exclusive positions it wants to advance after many months of

7
406672.05

DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 9 of 20

1 2

investigation lays bare the intellectual poverty of its position.5 e. The SEC cannot cure the deficiencies in its complaint by pointing at Mr. Trabulse's assertion of his Fifth Amendment rights.

3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Although the SEC does not say it directly, it has repeatedly implied that it should not be required to plead with particularity because Mr. Trabulse asserted his Fifth Amendment rights during the SEC's investigation. See Opp. at 10. This argument is both illogical and contrary to the weight of authority. Under Ninth Circuit law, an adverse inference is only permitted if the Court finds that there is: (1) independent corroborative evidence to support the negative inference; (2) a substantial need for the information; and (3) no less burdensome way to obtain it. See In re Tableware Antitrust Litig., 2007 WL 781960, at *4 (N.D. Cal. Mar. 13, 2007) (citing Doe v. Glanzer, 232 F.3d 1258, 1264-66 (9th Cir. 2000)). Under this framework, no adverse inference can or should be drawn here. In the first place, on a motion to dismiss, there can be no "independent corroborative evidence" because the only question at issue is whether the pleadings are legally sufficient. Navarro v. Block, 250 F.3d 729, 732 (9th Cir. 2001) (a motion to dismiss "tests the legal sufficiency of a claim"). Therefore, no adverse inference should enter into the Court's analysis of whether the allegations in the complaint are sufficient. Doe v. Glanzer, 232 F.3d at 1264 (an adverse "inference cannot be drawn when, for example, silence is the answer to an allegation contained in a complaint"). To put it another way--the purpose of an adverse inference is to establish that the alleged events actually took place or that an alleged state of mind actually existed. Thus, the whole concept of an adverse inference presupposes that there is a legally sufficient set of asserted facts against which the inference can act. Perhaps the easiest way to see this is to ask what would happen were the Court to attempt to impose an adverse inference in this case. What fact would the Court then infer from the
5

Moreover the SEC is not free, on this record, to argue that the non-securitized assets are immaterial because it repeatedly has advanced the contrary position. See, e.g., Complt. at ¶ 28 ("Trabulse used a significant portion of investor money ..."); Plaintiff's Motion for Preliminary Injunction at 9 ("Trabulse used a significant portion of investor money to purchase items such as 8
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 10 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

defendants' silence? It is one thing for the Court to infer that the defendant has committed acts alleged in a complaint, it is another thing entirely for the Court--at the SEC's urging--to write into the complaint unalleged facts to save it from dismissal. No court has, as far as defendants are aware, ever done such a thing. Indeed, while no Court has yet addressed the issue, these reasons (and others) have led the vast majority of academics to conclude that asserting the Fifth Amendment during an SEC investigation should not give rise to an adverse inference in any subsequently filed litigation.6 It is also important that the Court note that the SEC's Fifth Amendment argument is highly misleading. In particular, the SEC implies that it should be excused from having a factual basis to allege what the entire Fund was worth because "Trabulse refused to answer the Commission's questions about the location of the fund's bank accounts and brokerage account; how the fund calculated its profits gains and losses; how Trabulse calculated his compensation; and how the fund valued its assets." Opp. at 10. While it is literally true that Mr. Trabulse refused to answer the SEC's questions, this statement is misleading insofar as it implies the SEC did not have access to the underlying information. In particular, Mr. Trabulse produced thousands of pages of documents, including, for example, the very records from the bank and brokerage accounts he supposedly refused to identify. Further, all of the Fund's employees (including the Fund's limited general partner) did testify in the SEC's investigation. Thus, the fact that the SEC has no factual basis to allege, and therefore has not alleged, what the Fund was worth is due entirely to the SEC's strategic decision not to appraise the Fund's diverse assets. Mr. Trabulse's assertion of his rights has nothing to do with it. pearl necklaces and other jewelry, real property, and rugs."). 6 See, e. Carl Loewenson, D&O Liability & Insurance 2004: Directors & Officers Under Fire, Parallel Proceedings, 865 PLI/Comm 641, 650-52 (2004) ("it is constitutionally impermissible to draw an adverse inference based on a witness's assertion of the privilege against selfincrimination during an SEC investigation (as opposed to a pending S.E.C. case)."); Daniel W. Levy & Carl Loewenson, Taking the Fifth During SEC Probe, Client's Assertion of Rights Should be Irrelevant in Later Civil Enforcement, 7/16/2001 N.Y.L.J. 9 (col. 5) (2001) ("the assertion of Fifth Amendment rights during an SEC investigation is legally irrelevant during a subsequent civil enforcement action"); Wallace L. Timmeny, S.E.C. Proceedings - An Overview, C873 ALI-ABA 93, 106-07 (1993) ("The SEC should not succeed in its efforts to have an adverse inference drawn from an individual's assertion of the Fifth Amendment during an investigation because the investigative proceeding is non-adversarial in nature."). 9
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 11 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

2.

The SEC has failed to allege facts giving rise to an inference of materiality.

Under Ninth Circuit law, the question of materiality turns on whether "there is a substantial likelihood that a reasonable investor would have acted differently if the misrepresentation had not been made or the truth had been disclosed." Livid Holdings LTD. v. Salomon Smith Barney, Inc., 416 F.3d 940, 946 (9th Cir. 2005) (emphasis added) (citation omitted); see also In re Intrabiotics Pharms. Sec. Litig., 2006 U.S. Dist. LEXIS 56427 (N.D. Cal. Aug. 1, 2006) (J. White) (holding that plaintiffs did not meet materiality obligation where they had not "alleged sufficient facts that, if true, would demonstrate ... `a substantial likelihood that a reasonable investor would have acted different if the misrepresentation had not been made or the truth had been disclosed.'") (quoting Livid Holdings LTD. v. Salomon Smith Barney, Inc., 416 F.3d 940, 946 (9th Cir. 2005)).7 Thus, although the SEC does not need to establish or allege actual reliance, it must allege facts giving rise to a reasonable inference than an investor would have changed how it invested. See Livid Holdings LTD., 416 F.3d at 946 (holding that a misrepresentation "is material if there is a substantial likelihood that a reasonable investor would have acted differently if the misrepresentation had not been made or the truth had been disclosed.") (citation omitted). Yet, as noted in the defendants' opening brief, many of the (vague) statements and omissions gestured to by the SEC took place after the investment decisions to which they purportedly relate, and deal with aspects of Fund management that have no impact on the investors. Instead of addressing this point, the SEC argues that its allegations should just be deemed material because "[c]ourts have found that information, such as how investor funds are used, may be material as a matter of law." Opp. at 13. Yet the only case the SEC cites to support this proposition, Koehler v. Pulvers, 614 F. Supp 829, 842 (S.D. Cal. 1985), says no such thing. The Koehler case dealt with the question of whether a challenged security offering was or was not exempt from registration. In that context the Court found that purchasers of unregistered securities "must be shown to have been in a position to acquire" information similar to what is See also SEC v. Sandifur, 2006 U.S. Dist. LEXIS 12243 (D. Wash. Mar. 2, 2006) (applying same standard where SEC was plaintiff); S. Ferry LP # 2 v. Killinger, 399 F. Supp. 2d 1121, 10
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA
7

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 12 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

available under the 1933 Act, including "accurate information on the use of investor funds" before "an offering can be regarded as nonpublic and exempt." Id. at 842. Thus, the Koehler case had nothing to do with whether any alleged statement or omission was or was not material. Indeed, the law is clear that the question of materiality is not a question of law, but is instead a mixed question of fact and law that should be resolved by a jury whenever the alleged facts (taken as true) could support an inference of materiality. See French v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 784 F.2d 902, 906 (9th Cir. 1986) ("In the federal context, the question of materiality is a mixed question of law and fact"). Thus, under Rule 9(b), the SEC must allege specific facts that, if accepted, could lead a reasonable fact finder to conclude that a statement was material and, where it has not, it has not adequately alleged materiality. But many of the SEC's allegations fail under this standard. Thus, for example, Trabulse's alleged failure to "inform investors that he used their funds to purchase personal items for his family" or his alleged failure to clearly identify what was personal compensation and what was an expense of the fund cannot be material because (given the Fund's structure) they relate to aspects of Fund management that have no bearing on the risk or return of the Fund. Because no reasonable juror could conclude that information that has no possible bearing on his investment is material to the investment decision, the SEC has failed to adequately allege materiality. 3. The SEC has not identified allegedly false statements that occurred in connection with the purchase or sale of a security.

20 21 22 23 24 25 26 27 28

In its opposition, the SEC argues that the requirement that an allegedly misleading statement be made "in connection with the purchase or sale of a security" does not require it to identify a relationship between the alleged misstatement and the purchase or sale of a security. Instead, according to the SEC, the mere fact that the alleged misstatement was put into a document is sufficient to satisfy the "in connection with" requirement. Opp. at 9, 14. But this argument is both legally and logically incorrect. In the first place, the case on which the SEC relies , SEC v. Rana Research, Inc., 8 F.3d 1358 (9th Cir. 1993), explicitly deals 1137 (D. Wash. 2005) (applying same standard). 11

406672.05

DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 13 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

with situations in which the alleged fraud "involves public dissemination in a document such as a press release, annual report, investment prospectus or other such document." Id. at 1362 (emphasis added). But, of course, as alleged in the complaint, the Fahey Fund is a hedge fund-- i.e. a private investment vehicle that does not and cannot issue public quarterly reports. And there is no allegation in the complaint that the personalized quarterly reports issued by the Fund were, in fact, public. Such non-public communications cannot be deemed to be "in connection with the purchase and sale of a security" simply because they are written down. As the Supreme Court has put it, the securities laws "must not be construed so broadly as to convert every common-law fraud that happens to involve securities into a violation of § 10(b)." SEC v. Zandford, 535 U.S. 813, 820 (2002). In other words, if the "in connection with" requirement means anything it means that a private communication between a hedge fund manager and an investor, which is not made in connection with any transaction, falls outside the scope of the statute. Perhaps recognizing that it cannot rest on this strained reading of the case law, the SEC argues, in the alternative, that it has pled the necessary connection between the alleged misstatements and the purchase or sale of a security. In particular, the SEC argues that "contrary to defendants' assertion, the Complaint further alleges that [Mr. Trabulse] used the false and misleading account statements to solicit new investments and convince existing investors to put additional money into the fund." Opp. at 14-15. But the SEC's response completely ignores its obligation to plead with particularity. Which investors? What misrepresentations did they rely on? When did they supposedly invest? The complaint gives no information whatsoever about the circumstances that make up the alleged connection between the (unidentified) misstatement and the (vaguely) alleged purchase of an interest in the Fund. For this reason the SEC has utterly failed to set forth with particularity "the time, place, and nature of the misleading statements, misrepresentations, and specific acts of fraud." Kaplan, 49 F.3d at 1370; see also Moore, 96 F.3d at 1245. B. The SEC has not alleged facts to support the third cause of action. The SEC's third cause of action, for a violation of § 206 Investment Advisors Act, 12
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 14 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

requires a specific allegation of a breach of duty to the Fund itself, rather than to the Fund's investors. See Goldstein v. SEC, 451 F.3d 873, 881 (D.C. Cir. 2006) (holding that, under the Advisers Act, hedge fund managers owe "fiduciary duties only to the fund, not to the fund's investors.") (emphasis added); Merrill Scott & Associates, Ltd., 505 F. Supp. 2d 1193, 1212 (D. Utah 2007) (listing elements of the claim); Rauscher, 17 F. Supp. 2d at 988-90 (applying Rule 9(b) to claims under § 206). Despite this requirement, the SEC attempts to bootstrap itself into an Investment Advisors Act claim by relying on its (deficient) allegations under the Securities and Exchange Acts. In particular, the SEC claims that "[c]onduct that violates the antifraud provisions of the Exchange Act and Securities Act also may constitute a breach of an investment adviser's fiduciary duties to his clients, under Section 206 of the Advisors Act." Opp. at 8. But this is just wrong. The only case the SEC cites to support this proposition, SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), held only that investment advisors owe fiduciary duties to their clients. But the only client a hedge fund general partner has is the Fund itself--not the Fund's investors. See Goldstein, 451 F.3d at 880 ("As applied to limited partnerships and other entities, the Commission had interpreted this provision to refer to the partnership or entity itself as the adviser's `client.' ... This type of direct relationship exists between the adviser and the fund, but not between the adviser and the investors in the fund. The adviser is concerned with the fund's performance, not with each investor's financial condition."). Thus, the Exchange and Securities Acts apply to misrepresentations made to investors while the Advisors Act applies to breaches of duty to the Fund. Because the Acts apply to different groups, the SEC cannot bootstrap its allegations under the former into a claim under the latter. More fundamentally, nothing about the SEC's arguments changes the fact that it has failed to allege, even in rough terms, how much money Mr. Trabulse allegedly spent from the Fund, or what he was entitled to spend. The reason for this failure is that the SEC did not bother to do the leg work during their pre-filing investigation. The SEC has all of the Fund's records. It could have--as part of its prefiling investigation--obtained an independent valuation of the 13
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 15 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Fund's diverse holdings, but it chose not to. Similarly, it could have calculated the amount of money spent on the combination of expenses and compensation, but did not. So, instead, the SEC has taken actions against the Fund without a factual basis to contend that Mr. Trabulse spent more than he was entitled to spend and without being able to plead the specific allegations necessary to make out a claim under Rule 9(b). See Semegen v. Weidner, 780 F.2d 727, 731 (9th Cir. 1985) (Rule 9(b) "prevents the filing of a complaint as a pretext for the discovery of unknown wrongs and protects potential defendants--especially professionals whose reputations in their fields of expertise are most sensitive to slander--from the harm that comes from being charged with the commission of fraudulent acts."). In addition, the SEC makes the surprising argument that Trabulse was not authorized to spend money from the Fund on personal compensation because the Partnership Agreement says that "[n]o partner shall be entitled to any salary, but the General Partner shall receive the right to draw expenses consistent with prudent and sound management of the trading activities, such expenses being charged against his share." Opp. at 16 (citing § 6.06). This argument is surprising because the SEC's citation to the Partnership Agreement disproves the very point the SEC was trying to establish. Specifically, the Partnership Agreement says in black and white that Mr. Trabulse was entitled to "draw expenses" from the fund and "charg[e] them against his share." See id. Thus, if anything, this provision shows that the SEC's allegation that Trabulse violated his fiduciary duty by charging expenses to the Fund is just hot air. Moreover, insofar as the SEC is attempting to rely on the idea that Mr. Trabulse must withdraw expenses in a way that is "consistent with prudent and sound management of the trading activities," the SEC has made zero supporting allegations. Thus, for example, the SEC has made no allegation that any of Mr. Trabulse's withdrawals occurred at a time that interfered with a pending trade or anything of the kind. Again, under Rule 9(b), the SEC must be explicit about how and why an activity is alleged to violate a fiduciary duty to the Fund. See Baxter, 2007 WL 2013958, at *3. If the SEC now wishes to contend that Trabulse somehow violated his obligations under this provision of the Partnership Agreement it must plead that allegation in the complaint. That is, after all, the entire point of Rule 9(b). 14
DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

406672.05

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 16 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Finally, nothing in the SEC's opposition addresses the point (in the defendants' opening brief) that the structure of the Fund required Mr. Trabulse to pay business expenses out of his personal compensation thereby making it impossible to separate the two categories of expenses. See Defendants' Motion to Dismiss ("Motion") at 14. The SEC totally ignores this point and, instead, just repeats its allegation that Mr. Trabulse breached a fiduciary duty to the Fund by "commingling his assets with those of the Fund." Opp. at 16. But this allegation is irrelevant because the Partnership agreement required that Fund expenses and personal compensation be paid from the same funds. And the SEC's claim that Mr. Trabulse failed to maintain accurate accounting records by improperly recording business and personal expenses fails for the same reason--i.e. nothing turns on whether a particular expense was characterized as a business expense or a personal expense because, from the Fund's perspective, both sets of expenses are treated identically. For this reason, and as discussed above, the Complaint fails under Rule 9(b). III. Conclusion

The SEC has tremendous power. It has investigatory powers that other plaintiffs can only dream of, and the law permits it to bring actions that other plaintiffs cannot. But with great power comes great responsibility. In return for this grant of extraordinary authority comes the obligation for the SEC to diligently use its powers to understand the facts before bringing suit, with all its attendant publicity and the resulting damage to a defendant's business. In this case, the SEC has failed to live up to its part of the bargain. It did not attempt either to ascertain the value of the funds "other" assets or to determine whether Mr. Trabulse spent more than the 25% to which he was contractually entitled. Given the SEC's resources and authority, it is only appropriate it be held to the standards of Rule 9(b). Because the SEC has not met that standard, the defendants ask the Court to require the SEC to replead with the legally required specificity. Dated: November 21, 2007 By: KEKER & VAN NEST, LLP /s/ Clement S. Roberts _____________ CLEMENT S. ROBERTS Attorneys for Defendants ALEXANDER JAMES TRABULSE, FAHEY FUND, L.P., FAHEY FINANCIAL GROUP, INC., INTERNATIONAL TRADE & DATA, and ITD TRADING 15

26 27 28

406672.05

DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 17 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 16
406672.05

DEFENDANTS' REPLY ISO MOTION TO DISMISS CASE NO. C-07-4975 WHA

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 18 of 20

1 2 3 4 5 6 7 8 a. 9 10 11 12 13 14 15 16 17 18 19 3. 20 21 22 23 24 25 26 27 28 III. B. 2. e. d. c. b. I. II.

TABLE OF CONTENTS Page

Introduction..........................................................................................................................1 Argument .............................................................................................................................2 A. The SEC's first and second causes of action must be dismissed.............................2 1. The SEC has not alleged specific misstatements or omissions, nor has it offered a factual basis to allege falsity.........................................2 The SEC has not identified specific statements in the quarterly reports. ..............................................................................3 The SEC has not alleged (and does not have) a basis for asserting that the quarterly reports overstated the Fund's value.................................................................................................4 The SEC has not identified any allegedly false statements to investors about the kind of assets in which the Fund would invest......................................................................5 The SEC has not adequately alleged the quarterly reports omitted information about the kind of assets in which the Fund invested. ..................................................................................6 The SEC cannot cure the deficiencies in its complaint by pointing at Mr. Trabulse assertion of his Fifth Amendment rights............................................................................8

The SEC has failed to allege facts giving rise to an inference of materiality. .................................................................................................10 The SEC has not identified allegedly false statements that occurred in connection with the purchase or sale of a security..................11

The SEC has not alleged facts to support the third cause of action.......................12

Conclusion .........................................................................................................................15

DEFENDANT'S REPLY ISO MOTION TO DISMISS

ii
406672.055

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 19 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
406672.05

TABLE OF AUTHORITIES Page FEDERAL CASES Doe v. Glanzer, 232 F.3d 1258 (9th Cir. 2000) .................................................................................................8 French v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 784 F.2d 902 (9th Cir. 1986) .................................................................................................11 In re GlenFed, Inc. Sec. Litigation, 42 F.3d 1541 (9th Cir. 1994) ...............................................................................................4, 5 Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006) .........................................................................................12, 13 In re Intrabiotics Pharms. Sec. Litigation, 2006 U.S. Dist. LEXIS 56427 (N.D. Cal. Aug. 1, 2006).......................................................10 Kaplan v. Rose, 49 F.3d 1363 (9th Cir. 1994) cert. denied, 516 U.S. 810 (1995).......................................3, 12 Koehler v. Pulvers, 614 F. Supp. 829 (S.D. Cal. 1985)...................................................................................10, 11 Livid Holdings LTD. v. Salomon Smith Barney, Inc., 416 F.3d 940 (9th Cir. 2005) .................................................................................................10 Merrill Scott & Associates, Ltd., 505 F. Supp. 2d 1193 (D. Utah 2007)....................................................................................13 Moore v. Brewster, 96 F.3d 1240 (9th Cir. 1996) .............................................................................................3, 12 Navarro v. Block, 250 F.3d 729 (9th Cir. 2001) ...................................................................................................8 In re Read-Rite Corp., 335 F.3d 843 (9th Cir. 2003) ...................................................................................................6 SEC v. Baxter, 2007 WL. 2013958 (N.D. Cal. Jul. 11, 2007)M ................................................................3, 14 SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963)...............................................................................................................13 SEC v. Phan, 500 F.3d 895 (9th Cir. 2007) ...................................................................................................2 SEC v. Rana Research, Inc., 8 F.3d 1358 (9th Cir. 1993) .............................................................................................11, 12 SEC v. Rauscher Pierce Refsnes, Inc., 17 F. Supp. 2d 985 (D. Ariz. 1998) ...................................................................................7, 13 SEC v. Sandifur, 2006 U.S. Dist. LEXIS 12243 (D. Wash. Mar. 2, 2006) .......................................................10 SEC v. Yuen, 221 F.R.D. 631 (C.D. Cal. 2004) .............................................................................................5 SEC v. Zandford, 535 U.S. 813 (2002)...............................................................................................................12

iii}
DEFENDANTS' REPLY ISO MOTION TO DISMISS

Case 3:07-cv-04975-WHA

Document 45

Filed 11/21/2007

Page 20 of 20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
406672.05

TABLE OF AUTHORITIES Page S. Ferry LP # 2 v. Killinger, 399 F. Supp. 2d 1121 (D. Wash. 2005) .................................................................................10 Semegen v. Weidner, 780 F.2d 727 (9th Cir. 1985) .............................................................................................4, 14 In re Tableware Antitrust Litigation, 2007 WL. 781960 (N.D. Cal. Mar. 13, 2007)..........................................................................8 FEDERAL STATUTES 15 U.S.C. § 77q(a) .....................................................................................................................2, 6 15 U.S.C. § 78u-4 ..........................................................................................................................4 15 U.S.C. 78j(b) ........................................................................................................................2, 6 17 C.F.R. § 240.10b-5............................................................................................................2, 6, 7 Fed. R. Civ. Pro. 9(b) .......................................................................................................... passim OTHER AUTHORITIES Daniel W. Levy & Carl Loewenson, Taking the Fifth During SEC Probe, Client's Assertion of Rights Should be Irrelevant in Later Civil Enforcement, 7/16/2001 N.Y.L.J. 9 (2001) ...........................................................9 Carl Loewenson, D&O Liability & Insurance 2004: Directors & Officers Under Fire, Parallel Proceedings, 865 PLI/Comm 641, 650-52 (2004) ....................................................9 Wallace L. Timmeny, S.E.C. Proceedings - An Overview, C873................................................................................9

iiii}
DEFENDANTS' REPLY ISO MOTION TO DISMISS