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. e du/thir dc ir c uit_2001/265Filed November 16, 2001

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 00-2428

GFL ADVANTAGE FUND, LTD., a British Virgin Islands Corporation,

v.

DOUGLAS R. COLKITT

Douglas Colkitt Appellant

On Appeal from the United States District Court for the Middle District of Pennsylvania (No. 4:CV-97-0526) District Judge: Honorable James F. McClure, Jr.

Argued October 9, 2001

Before: SCIRICA, GREENBERG and COWEN, Circuit Judges

(Filed: November 16, 2001)

Peter S. Russ (argued) Gregory J. Krock Buchanan Ingersoll One Oxford Centre, 20th Floor

301 Grant Street Pittsburgh, PA 15219-1410

Attorneys for AppelleePeter Konolige

Marcy L. Colkitt & Associates, P.C. 983 The Woods, Suite 618 Old Eagle School Road Wayne, PA 19087

James P. Kimmel, Jr. (argued)

P.O. Box 1139 Kennett Square, PA 19348

Attorneys for Appellant

OPINION OF THE COURT

GREENBERG, Circuit Judge:

This matter comes on before this court on defendant Douglas R. Colkitt's appeal from the district court 's order for summary judgment in favor of plaintiff GFL Adva ntage Fund, Ltd. against Colkitt entered on April 25, 200 0, and on appeal from an order entered on July 17, 2000, d enying reconsideration of the April 25 order. For the reas ons stated herein, we will affirm the orders of the district c ourt.

I. BACKGROUND

A. FACTUAL HISTORY

Douglas Colkitt, who earned both his medical degree and MBA from the University of Pennsylvania in 1979, is the founder and majority shareholder of two small capitalization medical services businesses -- EquiM ed, Inc. ("EquiMed") and National Medical Financial Services Corporation ("National Medical"). As of February 19 96, Colkitt held 20,783,633 (73%) of EquiMed's 28,589,7 17 outstanding shares of common stock, and as of May 1 996, he owned 2.8 million (38%) of National Medical's 7, 426,844 outstanding shares of common stock. See GFL Advanta ge Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and Order at 4 (M.D. Pa. July 17, 2000).

Beginning in 1996, Colkitt sought financing to purs ue various business ventures unrelated to EquiMed and

2National Medical. After unsuccessfully attempting t o secure

financing from traditional commercial lending insti tutions, Colkitt contacted alternative lenders that might be willing to structure "convertible or exchange transactions, " whereby Colkitt would be able immediately to conver t his vast stockholdings into cash. In particular, Colkit t endeavored to borrow money by pledging his common s tock as collateral and providing the lender with the rig ht to convert or exchange the debt for the shares pledged by

Colkitt.

In the spring of 1996, Colkitt's broker identified GFL Advantage Fund, Ltd. ("GFL") as a possible lender, and on May 24, 1996, Colkitt obtained a loan of $3,000,000 from GFL. Under the terms of the note ("National Medical note"), GFL had the right after 30 days of the date of the note to exchange up to $1.5 million of its outstanding prin cipal for shares of National Medical stock held by Colkitt at an exchange rate of 82% of the average market price. G FL could exchange the remainder of the unpaid balance for shares of National Medical 60 days after the date o f the note. The average market price was computed by taki ng the average of the stock's closing prices for the five days immediately prior to the exchange request. In essen ce, the note gave GFL the right to require Colkitt to repay the loan

with National Medical stock valued at a discount of 18% of the five-day average closing price, thus giving GFL an immediate paper profit as it would receive stock wi th a premium value to repay a debt of a lesser amount.

Several months later on August 5, 1996, Colkitt ent ered into a similar transaction with GFL for a $10,000,0 00 loan. The structure of the second note ("EquiMed note") w as akin to that of the National Medical note, except the pa rties agreed that GFL could convert the debt into shares of Colkitt's other business, EquiMed, Inc., at an exch ange rate of 83% of the average market price. In addition, GF L could convert up to $5 million of the outstanding princip al after 60 days of the date of the note and could convert t he balance of the principal 30 days thereafter.

Nearly four months after issuing the initial $3,000 ,000 loan to Colkitt, GFL made its first of six exchange demands for National Medical stock. On September 13, 1996, GFL

3exchanged $250,000 of debt for 34,130 shares of Nat ional

Medical stock at the average market price of $9.20 and an exchange or conversion price of $7.32. On September 19, 1996, GFL exchanged $135,000 of loan principal for 18,726 shares at an average market price of $9.075 and a conversion price of $7.21. On October 10, 1996, GFL converted $257,000 of debt into 47,081 shares at an average closing price of $6.925 and a conversion pr ice of $5.46. On December 5, 1996, GFL exchanged $100,000 of unpaid principal for 14,845 shares at an average ma rket price of $8.725 and an exchange price of $6.74. On December 19, 1996, GFL converted $200,000 of debt i nto 34,588 shares at an average market price of $7.525 and a conversion price of $5.78. Finally, on January 7, 1 997, GFL demanded an exchange of $545,000 of loan principal for 100,223 shares, but the request was withdrawn after Colkitt dishonored GFL's earlier exchange demand fo r EquiMed stock.

GFL waited until November 1996, more than 3 months after the date of the EquiMed note, before making i ts first exchange demand for EquiMed shares. On November 27, 1996, GFL demanded that Colkitt convert $560,000 in outstanding principal into EquiMed stock. With a fi ve-day average closing price of $4.50, GFL received 150,55 5 shares of EquiMed at an exchange rate price of $3.72. GFL' s next exchange demand for EquiMed stock occurred on Janua ry 3, 1997, when GFL sought to convert $1,430,000 in u npaid principal, but Colkitt dishonored the request.

Unknown to Colkitt at the time, and on the same day in September 1996 as GFL's first exchange demand for National Medical stock, GFL began short selling Nat ional Medical stock. As we have explained:

Short selling is accomplished by selling sto ck which the investor does not yet own; normally this is done by borrowing shares from a broker at an agreed upon fee

or rate of interest . . . . The short seller is obligated, however, to buy an equivalent number of shar es in

order to return the borrowed shares . . . . Herein lies the short seller's potential for profit: if the price of stock declines after the short sale, he does not need all the funds to make this covering purchase; th e short

4seller then pockets the difference. On the o ther hand,

there is no limit to the short seller's pote ntial loss: if the price of the stock rises, so too does th e short seller's loss, and since there is no cap to a stock's price, there is no limitation on the short s eller's risk.

Zlotnick v. Tie Communications, 836 F.2d 818, 820 ( 3d Cir. 1988). See also 17 C.F.R. S 240.3b-3 (defining shor t sale as "any sale of a security which the seller does not o wn or any sale which is consummated by the delivery of a secu rity borrowed by, or for the account of, the seller"); B lack's Law Dictionary 1339 (7th ed. 1999) (defining short sale as the "sale of a security that the seller does not own or has not contracted for at the time of sale, and that the se ller must borrow to make delivery"). In other words, short se llers are betting that the stock price will decline between t he time they sell the borrowed stock and the time they must "cover," i.e., purchase replacement shares to repay the borrowed stock. Short selling, which is closely reg ulated, see, e.g., 17 C.F.R. S 240.10a-1, is a legitimate t rading strategy for stocks that traders believe are overva lued.

GFL's first short sale of National Medical stock oc curred on September 13, 1996, when it sold 32,500 shares a t a price of $10.00 per share. On September 16, 1996, G FL sold short 15,000 shares of National Medical at $9. 13 per share. On September 17, 1996, GFL sold short 5,000 shares at $9.25 per share. On October 11, 1996, GFL sold short 3,000 shares at $8.25 per share. Finally, on October 14, 1996, GFL sold short 7,000 shares of National M edical at $8.25 per share. GFL sold short a total of 62,50 0 shares of National Medical stock over a one-month period.

GFL also sold EquiMed shares short. On November 8, 1996, GFL sold short a total of 18,400 shares of Eq uiMed -- 10,000 shares at $5.50 per share and 8,400 share s at $5.48 per share. On November 11, 1996, GFL sold sho rt 32,500 shares at $5.38 per share. On November 12, 1 996, GFL sold short 16,000 shares at $5.25 per share. On November 14, 1996, GFL sold short 8,500 shares at $ 5.25 per share. Finally, on November 22, 1996, GFL sold short 3,300 shares of EquiMed stock at $5.00 per share. O ver this two-week period in November 1996, GFL sold sho rt a total of 78,700 shares of EquiMed stock.

5GFL explains that it engaged in short sales of Nati onal

Medical and EquiMed stock as a hedging strategy aga inst "delivery risk." Under the terms of the notes, the exchange price was based on the average closing price during the five trading days preceding the exchange request. Consequently, the exchange price was locked in on t he date of the exchange request, thus shifting onto GFL the risk that the stock's price would drop more than the 17% or 18% discount. In other words, "if the stock price d ropped more than the agreed-upon discount before GFL was a ble to sell the exchanged shares, GFL would be in a los s position." Br. of Appellee at 7. GFL claims it sold short to protect itself in the event that the price of the s tock declined further after GFL made the exchange reques t but

before GFL was able to sell the shares.

The theory of Colkitt's case, however, is that GFL sold National Medical and EquiMed shares short in an eff ort to depress the prices of the stocks. Indeed, Colkitt c ontends that the market price of National Medical dropped 1 7.5%

between GFL's first and last short sales of Nationa l Medical stock, and that the market price of EquiMed decline d by 18.5% between GFL's first short sale of EquiMed sto ck and GFL's first exchange demand.1 Colkitt argues that G FL purposely depressed the stock prices so that Colkit t would be forced to exchange more shares to retire the sam e amount of debt. He asserts that GFL was able to obt ain an additional 27,882 shares of EquiMed and an addition al 11,658 shares of National Medical due to the respec tive declines in the stocks' prices.

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1. Inexplicably, Colkitt measures the price decline of EquiMed stock during the period between GFL's first short sale on November 8, 1996, and GFL's first exchange demand on November 27, 199 6, rather than between GFL's first short sale on November 8, 1996, and its last short sale on November 22, 1996. As GFL points out, howev er, if the price decline of EquiMed stock is measured during the per iod between GFL's first and last short sales, EquiMed's price drop wo uld be approximately 2%. See Br. of Appellee at 36. More specifically, t he price of EquiMed on the day of the first short trade on November 8 was $5.25 per share, whereas the price on the day of the last short sale on November 22 was $5.13. See id. at 36 n.13. This $.12 drop represent s only a 2.3%

decrease.

6As noted above, Colkitt refused to honor GFL's exch ange

request for EquiMed shares on January 3, 1997. Inst ead, Colkitt notified GFL in December 1996 and early Jan uary 1997 that he intended to prepay all unpaid principa l and interest in cash. Colkitt contends that GFL imprope rly rejected his request to prepay the unpaid balance, even though the notes contemplated such prepayment. GFL responds that it did not reject outright Colkitt's offer to prepay, but rather refused to allow Colkitt to dict ate the terms of any prepayment and disagreed with Colkitt about

the amounts due. GFL admits that it does not believ e that Colkitt had a right to prepay, but insists that it" accepted Colkitt's offer to prepay whatever amount Colkitt b elieved was then due, reserving for itself the right to con test the disputed balance." Br. of Appellee at 13. GFL claim s that Colkitt neither responded to its overtures nor atte mpted to prepay or pay any amounts to GFL.

B. PROCEDURAL HISTORY

On April 4, 1997, GFL filed a complaint against Col kitt alleging breach of his obligations on the National Medical and EquiMed notes. On June 6, 1997, Colkitt filed a n answer, affirmative defenses, and six counterclaims . The affirmative defenses and counterclaims alleged, int er alia, that GFL engaged in securities fraud and market manipulation in violation of various federal and st ate securities laws by temporarily depressing the price s of National Medical and EquiMed stock through its

concentrated short sales. Colkitt claimed that GFL engaged in the scheme so that it could exchange debt for sh ares at an artificially low price and earn enormous windfal l profits when prices returned to their normal levels. On Mar ch 31, 1998, the district court adopted a magistrate judge 's

recommendations that Colkitt's counterclaims be

dismissed. The district court dismissed one counter claim with prejudice and the balance without prejudice. 2 On April

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2. The Court dismissed counterclaims I (Section 10( b) of the Security Exchange Act of 1934 and Rule 10b-5 under the Act), III (Section 29 of the Securities Exchange Act of 1934), IV (Pennsylva nia Securities Act), and V (common law fraud) without prejudice for lack of specificity. The court dismissed counterclaim II (Section 17 of the Securities Act of 1933)

720, 1998, Colkitt filed amended counterclaims in an effort

to cure the deficiencies of the original countercla ims, but on February 2, 1999, the district court again dismi ssed Colkitt's inadequately pled counterclaims without p rejudice for lack of specificity.

On April 25, 2000, the district court granted summa ry judgment in favor of GFL based largely on the reaso ning of In re Olympia Brewing Co. Securities Litigation , 6 13 F. Supp. 1286 (N.D. Ill. 1985). The court concluded th at, because short selling is not an unlawful trading pr actice, it would not draw the inference that GFL manipulated t he market price of EquiMed and National Medical stocks simply because GFL engaged in substantial short sel ling of

the stocks. The court also determined that Colkitt failed to present evidence that GFL's short sales had an appr eciable effect on the prices of the stocks. Finally, the co urt concluded that even if the short sales did depress prices, Colkitt failed to show that "the declines in price are attributable to false information injected into the market by

the short sales and not to information otherwise av ailable to the market." GFL Advantage Fund, Ltd. v. Colkitt , No. 4:CV-97-0526, Memorandum and Order at 22 (M.D. Pa. Apr. 25, 2000).

On July 17, 2000, the district court denied Colkitt 's motion for reconsideration and entered final judgme nt in

favor of GFL. The court clarified its earlier rulin g on GFL's motion for summary judgment, explaining that the ev idence

of GFL's short sales alone was insufficient to esta blish

Colkitt's claims of securities fraud and market manipulation because selling stocks short is lawful . The court declared that "[t]here must be some circumsta nces beyond the mere occurrence of short sales to sugges t that

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with prejudice, subject to reinstatement in the eve nt that we recognize a private right of action under Section 17 of the Sec urities Act of 1933, 15 U.S.C. S 77q(a). The court dismissed counterclaim c ount VI (unjust enrichment) without prejudice because the equitable remedy of unjust

enrichment is not available when a contract exists between the parties. Although the court initially dismissed count VI wit h prejudice, the court

concluded on reconsideration that the order was in error and changed the dismissal to a dismissal without prejudice.

8the short sales were part of a scheme to manipulate the

market," which Colkitt failed to proffer. GFL Advan tage Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and Order at 14 (M.D. Pa. July 17, 2000). The court the n proceeded to reject Colkitt's argument that numerou s inferences that he believed should be drawn from th e factual record created genuine issues of material f act that precluded summary judgment. The court refused to ac cept any of Colkitt's proffered inferences -- each of wh ich Colkitt has raised on appeal -- and reaffirmed its decision that GFL was entitled to summary judgment as a matter of law.

II. JURISDICTION AND STANDARD OF REVIEW

A. JURISDICTION

The district court had subject matter jurisdiction over GFL's breach of contract action pursuant to 28 U.S. C. S 1332 based upon diversity of the parties and the amount in controversy. The district court entered final ju dgment in this case on July 17, 2000, and appellant filed a t imely notice of appeal on August 15, 2000. Therefore, we have jurisdiction pursuant to 28 U.S.C. S 1291. 3

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3. As noted above, the district court twice dismiss ed certain of Colkitt's counterclaims without prejudice for lack of specifi city. In some circumstances, such a dismissal could deprive us of appellate jurisdiction as "ordinarily we do not have jurisdic tion under 28 U.S.C. S 1291 of an appeal from an order partially adjudic ating a case when an appellant has asserted a claim in district court wh ich it has withdrawn or dismissed without prejudice." Erie County Retire es Ass'n v. County of Erie, 220 F.3d 193, 201 (3d Cir. 2000). Our case la w, however, allows us to exercise appellate jurisdiction under 28 U.S.C.S 1291 when the

district court has divested itself of the case enti rely. See id. at 202.

Here, although the district court's orders dismissed Colk itt's counterclaims without prejudice, the court's summary judgment ord er effectively barred Colkitt from re-filing them, for the court conclude d that Colkitt's

affirmative defenses -- which were identical to his counterclaims -- failed as a matter of law. Consequently, the court' s order granting summary judgment in favor of GFL terminated the sui t so far as the

court was concerned. See Trent v. Dial Med. of Fla. , Inc., 33 F.3d 217, 220 (3d Cir. 1994) ("Even dismissals without prejud ice have been held to be final and appealable if they `end [ ] [the] suit so far as the District Court was concerned . . . .' ") (citation omitted). Therefore, we have jurisdiction over this appeal.

9B. STANDARD OF REVIEW

We review the district court's grant of summary jud gment de novo and apply the same standard as the district court applied in the first instance. See Lucent Info. Mgm t., Inc. v. Lucent Tech., Inc., 186 F.3d 311, 315 (3d Cir. 1999 ). We may affirm summary judgment in favor of GFL only if , after drawing all reasonable inferences from the record i n the light most favorable to Colkitt, "there is no genui ne issue as to any material fact" and GFL is "entitled to a jud gment as a matter of law." Fed. R. Civ. P. 56(c). As the non moving party, Colkitt must create a genuine issue of mater ial fact by presenting sufficient evidence to permit a jury to find in his favor. See Anderson v. Liberty Lobby, Inc. , 47 7 U.S. 242, 248, 106 S. Ct. 2505, 2510 (1986). To defeat summar y judgment, he "cannot rest simply on the allegations in the pleadings," but "must rely on affidavits, depositio ns, answers to interrogatories, or admissions on file." Bhatla v. U.S. Capital Corp., 990 F.2d 780, 787 (3d Cir. 1993 ). Therefore, it will be appropriate to affirm summary judgment for GFL if we conclude that there is insuf ficient evidence for a reasonable jury to return a verdict for

Colkitt.

III. DISCUSSION

A. RESCISSION OF THE NOTES PURSUANT TO SECTION

29

Colkitt contends that the National Medical and Equi Med notes are unenforceable by reason of Section 29 of the Securities Exchange Act of 1934 ("Exchange Act") be cause GFL violated the anti-fraud provisions under Sectio n 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder. Section 29(b) provides in relevant part that:

Every contract made in violation of any prov ision of this chapter or of any rule or regulation thereun der, . .. [or] the performance of which involves the violat ion of, or the continuance of any relationship or pract ice in violation of, any provision of this chapter or any rule or regulation thereunder, shall be void.

15 U.S.C. S 78cc(b) (emphasis added). Colkitt argue s that GFL violated Section 10(b) and Rule 10b-5 when it e ngaged

10in market manipulation by short selling National Me dical

and EquiMed stock in an effort to depress the share prices, and when it engaged in fraudulent deception by conc ealing its plan to short sell National Medical and EquiMed stock. See Br. of Appellant at 24. Colkitt asserts that th e notes are void and unenforceable under Section 29(b) because the notes were "made in violation of" Section 10(b) and Rule 10b-5 insofar as (1) they were part of GFL's scheme to manipulate the market prices of National Medical an d EquiMed stock and (2) they contain omissions of mat erial fact about GFL's short selling strategy. See Reply Br. of Appellant at 19.

GFL argues that Colkitt's Section 29(b) affirmative defense fails for two reasons. First, Section 29(b) is a remedial provision that is triggered only when anot her section of the Exchange Act has been violated. As addressed below, GFL maintains that it did not enga ge in either market manipulation or securities fraud in v iolation of Section 10(b), and therefore, there is no underl ying offense to trigger Section 29(b). See infra pp. 17- 36. Second, GFL contends that Colkitt fails to state a proper S ection 29(b) defense inasmuch as Colkitt alleges that it i s GFL's short selling, not the National Medical and EquiMed notes, that is unlawful. GFL argues that only "unlawful co ntracts," not "unlawful transactions" executed pursuant to la wful contracts, may be rescinded under Section 29(b).

We deal with GFL's second contention first, which i s supported by the limited body of case law on the po int. For instance, in Slomiak v. Bear Stearns & Co., 597 F. Supp. 676, 677 (S.D.N.Y. 1984), plaintiff opened a margin account and a repurchase account with defendant Bear Stearn s. He purchased millions of dollars of government bonds i n his margin account -- less than 10% with cash and the remainder with loans by Bear Stearns. See id. When plaintiff was notified of a margin call on his acco unt and failed to muster the $155,000 in additional margin demanded, Bear Stearns liquidated the government bo nds in plaintiff's account. See id. Plaintiff alleged t hat Bear Stearns violated Section 10(b) and Rule 10b-16 by f ailing to provide him at the time he opened his accounts with a written statement explaining the terms under which Bear

11Stearns would extend him credit. See id. Based on t hese

alleged violations, plaintiff sought to rescind all of his bond transactions pursuant to Section 29(b). See id. at 681. The court concluded that plaintiff could not rescind th e transactions, explaining:

The complaint alleges that Bear Stearns fail ed to send plaintiff a written credit disclosure statem ent in violation of Rule 10b-16 at the time he open ed his accounts; it does not allege that the custom er agreements establishing his margin and repur chase

accounts at Bear Stearns were themselves unl awful . . . . `[U]nder S 29 of the Exchange Act, o nly unlawful contracts may be rescinded, not unlawful tra nsactions made pursuant to lawful contracts.'

Id. at 681-82 (quoting Zerman v. Jacobs , 510 F. Su pp. 132, 135 (S.D.N.Y. 1981), aff'd, 672 F.2d 901 (2d Cir. 1 981) (table)). Because Bear Stearns's alleged violation of Rule 10b-16 was "clearly collateral to the contract agre ement governing the account," the court determined that t he firm's failure to provide the written statement to plaintiff did "not justify rescission of the account agreemen t itself or the transactions undertaken pursuant to that agreem ent."

Id. at 682-83.

In Drasner v. Thomson McKinnon Securities, Inc. , 4 33 F. Supp. 485, 488-89 (S.D.N.Y. 1977), plaintiffs maint ained margin accounts with defendant Thomson McKinnon Securities between 1973 and 1975. Plaintiffs began selling naked options in 1974 and profited handsomely off t he transactions until 1975, when the market began spik ing upward. See id. Between January and May 1975, plain tiffs incurred substantial losses on their options until Thomson McKinnon finally closed their accounts and liquidat ed their collateral. See id. at 489. Plaintiffs sought to re scind the options contracts pursuant to Section 29(b) because Thomson McKinnon allegedly violated Regulation T by failing to direct plaintiffs to deposit the require d amount of initial margin in their accounts. See id. The court rejected plaintiffs' claim, stating that Section 29(b) "only renders void those contracts which by their terms violate t he Act or the rules and regulations thereunder . . . for it i s only such contracts which are `made in violation of,' or`the

12performance of which involves the violation of' the statute

and the rules and regulations thereunder." Id. at 5 01-02. The court explained that even if Thomson McKinnon h ad violated Regulation T, Section 29(b) was inapplicab le because the options contracts that plaintiffs sough t to rescind were governed by a valid, lawful contract w hose terms did not violate the Exchange Act or any regul ations promulgated thereunder. See id. at 502.

Colkitt responds to GFL's argument by citing Region al Properties, Inc. v. Financial and Real Estate Consu lting Co., 678 F.2d 552, 560 (5th Cir. 1982), which challenges Drasner's narrow construction of Section 29(b). In Regional Properties, two real estate entrepreneurs brought s uit against their broker and his firm, Financial and Re al Estate Consulting Co. ("Financial"), alleging that the bro ker had violated Section 15(a)(1) of the Exchange Act by se lling limited partnership interests for them without havi ng registered with the SEC as a broker-dealer. See id. at 556. The entrepreneurs and their affiliated corporations sought to rescind their agreements with Financial pursuant to Section 29(b) in light of the broker's violations o f Section 15(a)(1). See id. The court rejected Drasner's conc lusion that Section 29(b) renders void only those contract s that "by their terms" violate the Exchange Act and inste ad interpreted Section 29(b) as "render[ing] voidable those contracts that are either illegal when made or as i n fact performed." Id. at 560. The court concluded that re scission was proper because, although plaintiffs sought to a void contracts that were "perfectly lawful on their face ," the performance of the contracts by Financial neverthel ess "resulted in a violation of the Act." Id. at 561. The court added: "That these contracts, under different circumstances, could have been performed without violating the Act is immaterial." Id.

Although the court of appeals in Regional Propertie s rescinded the contracts therein and explicitly reje cted Drasner's narrow reading of Section 29(b), its opin ion is

nevertheless consistent with the outcomes in Drasne r, Slomiak, and Zerman. In particular, the violations of the Exchange Act alleged in Drasner, Slomiak , and Zerm an were "collateral or tangential to the contract between t he

13parties," whereas the violation alleged in Regional Properties

was "inseparable from the performance of the contra ct" that plaintiffs were attempting to void. Slomiak, 597 F. Supp. at 682. The parties could -- and did -- perform the co ntracts at issue in Drasner, Slomiak, and Zerman without committing any violations of the Exchange Act, but the broker in Regional Properties could not carry out h is obligations under the agreements without violating the Exchange Act, for performance of the agreements ent ailed selling partnership interests, which the broker law fully could not do due to his failure to register as a br okerdealer.

The other two cases cited by Colkitt are also consi stent with this analysis. In both cases, the courts voide d loan agreements because the banks violated Regulation U, which governs the amount of money that a bank can lend fo r the purchase of registered securities. In Grove v. Firs t National Bank of Herminie, 489 F.2d 512, 513 (3d Cir. 1974) (per curiam), bank employees failed to explain to plaint iff that under federal law, the bank "could lend only a cert ain percentage of the market value of stock to purchase registered securities." Concluding that the bank ha d violated Regulation U, we held that Section 29(b) p recluded the bank from recovering a deficiency, "even if the borrower knowingly and intentionally deceives the bank as to the actual purposes of the loans." Id. at 516.

In Stonehill v. Security National Bank, 68 F.R.D. 2 4, 28 (S.D.N.Y. 1975), a bank sought to recover the outst anding balance on a loan, but the borrower claimed that th e loan

was void and unenforceable because the bank issued the loan in violation of Regulation U. The bank argued that even if the borrower's obligations were void due to the bank's alleged violation of Regulation U, it still could recover from the guarantor. See id. at 33. The cour t disagreed, holding that "if the principal obligatio n violates Regulation U, a guarantee of that obligation is voi d under S 29(b) of the Exchange Act." Id. The court explain ed that "allow[ing] a bank to recover on a guarantee even t hough the underlying loan violated Regulation U would enc ourage banks to extend credit in violation of the margin requirements." Id. at 34.

14As with the violation of Section 15(a)(1) in Region al

Properties, the violations of Regulation U in Grove and Stonehill were inseparable from the underlying agre ements between the parties: the banks could not perform th eir obligations under the loan agreements (i.e., lend m oney to the borrowers so that they could purchase securitie s) without violating Regulation U. In fact, the loans were "made in violation of" the Exchange Act because a g reater percentage of the loans was used to purchase securi ties than is allowed under Regulation U.

The same cannot be said for GFL's obligations under the National Medical and EquiMed notes in this case. GF L's allegedly unlawful short sales of National Medical and EquiMed stock were nothing more than "collateral or tangential" to the notes. Colkitt insists that perf ormance of

the contracts "involves a violation of" securities laws because "performance itself (exchange of shares and repayment of the loan plus interest) . . . supports GFL's illegal short selling by giving GFL shares with whi ch to cover the short sales." Br. of Appellant at 25 n.8. Despite the theory of Colkitt's case, however, GFL's short sales are completely independent of the parties' respective o bligations under the terms of the notes -- namely, GFL's oblig ation to lend Colkitt a total of $13,000,000, and Colkitt's obligation to repay the loans at GFL's option with shares of N ational Medical and EquiMed stock. In the end, GFL's allege d unlawful activity (i.e., its short sales) is too at tenuated from the parties' valid, lawful contracts (i.e., the Nat ional Medical and EquiMed notes) or GFL's performance thereunder. Therefore, we conclude that the notes were neither made nor performed in violation of any federal securitie s laws as is required for rescission under Section 29(b). 4

B. MARKET MANIPULATION

Colkitt argues that the district court erred in rej ecting his affirmative defense that the notes are void pursuan t to Section 29(b) due to GFL's alleged market manipulat ion, as

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4. Notwithstanding our conclusions as to the scope of Section 29(b), we will discuss the market manipulation and securities fraud issues as our conclusions on them are critical to our disposition of Colkitt's appeal from the dismissal of his counterclaims. See supra note 3.

15there exist genuine issues of material fact regardi ng

whether GFL's short sales constituted market manipu lation in violation of Section 10(b) and Rule 10b-5. GFL a rgues, however, that Colkitt has not presented enough evid ence to create triable issues on any of the elements of mar ket manipulation.5

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5. GFL also insists that Colkitt cannot obtain reve rsal of summary judgment with respect to GFL's alleged manipulation of National Medical's price because Colkitt abandoned his marke t manipulation and securities fraud claims with respect to National Me dical by conceding

that GFL's short sales of National Medical stock di d not violate any securities laws. See Br. of Appellee at 19-21. To s upport its contention, GFL quotes a passage from Colkitt's opposition to G FL's motion for summary judgment, which states that "[t]he short se lling of National Medical presents an interesting contrast to the sho rt selling of EquiMed." Id. at 20 (quoting Colkitt's Brief in Opposition to Summary Judgment at 6 (App. 000837)). GFL claims that this statement, a long with other unspecified passages in Colkitt's opposition and hi s motion for reconsideration, led the district court to limit it s rulings to only the EquiMed note.

GFL's argument is without merit. A review of the di strict court's April 25, 2000 Memorandum reveals that the court addresse d Colkitt's market manipulation and securities fraud claims as to both EquiMed and National Medical. Indeed, National Medical is menti oned throughout the district court's summary judgment and reconsiderati on rulings. There is no indication in the district court's rulings that Colkitt abandoned these claims or that the court limited its rulings to onl y the EquiMed note.

GFL also distorts the meaning of the above-quoted p assage by taking

it out of context. When Colkitt admitted that the s hort sales of National Medical differed in some respects to the short sale s of EquiMed, he was referring only to GFL's contention that it engaged in the short sales as a hedging strategy. As will be explained in more de tail below, see infra pp. 28-30, Colkitt's expert maintains that selling short prior to the

fiveday period before the exchange demand is not a legi timate hedging strategy, but instead an attempt to profit from dec lining stock prices. The expert insists that if GFL were only trying to hedge against a possible drop in price after the exchange demand (s o-called "delivery risk"), GFL could have eliminated that risk by sell ing short during the five-day period before the exchange demand -- in es sence, locking in the sale price during the same period the average closi ng price would be calculated. Colkitt's statement was simply an "ackn owledgment that, unlike the EquiMed shorts, the National Medical sho rts, by their timing, could at least qualify as a hedge strategy" because they were made

161. Elements of Market Manipulation Under Section 10 (b)

and Rule 10b-5

As an initial matter, the parties disagree about th e specific elements of market manipulation under Section 10(b) and Rule 10b-5. To complicate matters further, we seeme d not to have addressed squarely what elements are requir ed to establish a claim of market manipulation, particula rly in the context of a Section 29(b) affirmative defense, and the case law from other courts of appeals and district courts on this issue provides limited guidance. Section 10(b) states in relevant part that "[i]t shall be unlawful for any person . . . [t]o use or employ, in connection with the pu rchase or sale of any security . . ., any manipulative or dec eptive

device or contrivance in contravention of such rule s and regulations" promulgated by the SEC. 15 U.S.C.S 78j . Rule 10b-5 provides in relevant part that "[i]t shall be unlawful for any person . . . [t]o employ any device, scheme , or artifice to defraud." 17 C.F.R. S 240.10b-5.

Noting that Section 10(b) outlaws but does not defi ne a "manipulative or deceptive device or contrivance," Colkitt turns to Section 9(a) of the Exchange Act to determ ine the elements of the offense of market manipulation. Sec tion 9(a) prohibits individuals from effecting "a series of transactions in any security registered on a nation al securities exchange . . . creating actual or appare nt active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the p urchase or sale of such security by others." 15 U.S.C.S 78i (a)(2). Based on this passage and the Supreme Court's decis ion in Aaron v. SEC, 446 U.S. 680, 695, 100 S.Ct. 1945, 19 55 (1980), in which the Court recognized scienter as a n element of a Section 10(b) claim, Colkitt maintains that summary judgment was improper because he created genuine issues with respect to each of the followin g

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within the days immediately preceding GFL's exchang e demands for National Medical stock. Reply Br. of Appellant at 5 . This narrow admission cannot be construed as a complete waiver of his counterclaims and affirmative defenses with respect to the National

Medical note.

17elements of market manipulation: (1) GFL engaged in a

series of transactions in the registered securities ; (2) the purpose of GFL's short sales was to induce others t o sell the securities; (3) GFL's short sales created "actu al or apparent active trading" in the securities or depre ssed the prices of the securities; and (4) GFL acted with sc ienter.

GFL responds that Colkitt has mischaracterized the elements of market manipulation by applying an over ly broad description of prohibited activities set fort h under Section 9(a) and by ignoring the specific requireme nts of market manipulation that have evolved over time. GF L points out that market manipulation is "virtually a term of

art when used in connection with the securities mar ket. It connotes intentional and willful conduct designed t o deceive or defraud investors by controlling or arti ficially affecting the price of securities." Ernst & Ernst v

. Hochfelder, 425 U.S. 185, 199, 96 S.Ct. 1375, 1384 (1976). GFL asserts that Colkitt disregards two necessary e lements of a market manipulation claim -- that "GFL injecte d inaccurate information into the marketplace" and th at GFL's conduct "affected the price" of National Medi cal and EquiMed stock. Br. of Appellee at 24.

The first disputed element is whether Colkitt must demonstrate that GFL injected inaccurate informatio n into the marketplace or created a false impression of ma rket activity. Like the district court, GFL relies on Ol ympia Brewing, 613 F. Supp. at 1292, in which the distric t court emphasized that the "essential element" of a market manipulation claim is the injection of "inaccurate

information" into the market. GFL observes that eve n the cases cited by Colkitt "recognize that market manip ulation requires an additional element, something beyond otherwise legal trading, which specifically injects false information into the market and/or creates an artif icial demand for the underlying security." Br. of Appelle e at 22 (emphasis added). Colkitt responds, however, that h e is not required to present evidence that "GFL injected aff irmative misinformation into the market," but only needs to

demonstrate that "GFL's short trades were made for the undisclosed purpose of artificially depressing shar e prices." Reply Br. of Appellant at 9 (emphasis added).

18Notwithstanding Colkitt's assertion to the contrary , the

parties appear to be in accord on this point. Indee d, the difference between their positions seems to be one without

distinction. Both GFL and Colkitt focus on the need to

demonstrate that some action was taken to artificia lly depress or inflate prices, whether by purposely mak ing false statements or by employing illegitimate, dece ptive trading techniques that mislead investors about the price or

demand for a stock.

To the extent that the parties' respective position s are at odds, however, GFL advances a sounder construction of a Section 10(b) market manipulation claim, for it is less vague than Colkitt's. The Supreme Court has indicat ed that market manipulation "generally refers to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affec ting market activity." Santa Fe Indus. v. Green, 430 U.S. 462, 476, 97 S.Ct. 1292, 1302 (1977). "The gravamen of manipulat ion is deception of investors into believing that prices a t which they purchase and sell securities are determined by the natural interplay of supply and demand, not rigged by manipulators." Gurary v. Winehouse, 190 F.3d 37, 45 (2d Cir. 1999). In that vein, courts must distinguish b etween legitimate trading strategies intended to anticipat e and respond to prevailing market forces and those desig ned to manipulate prices and deceive purchasers and seller s. Although Colkitt's construction properly reflects t he aspiration of Section 10(b) of preventing market ac tivities that artificially depress prices, it provides littl e guidance on which activities artificially affect prices and whi ch activities legitimately impact prices.

Requiring a Section 10(b) plaintiff to establish th at the alleged manipulator injected "inaccurate informatio n" into the market or created a false impression of market activity cures this problem. Such a construction permits cou rts to differentiate between legitimate trading activities that permissibly may influence prices, such as short sal es, and "ingenious devices that might be used to manipulate securities prices," Santa Fe Indus., 462 U.S. at 47 7, 97 S. Ct. at 1303, such as wash sales and matched orders. As the court in Olympia Brewing, 613 F. Supp. at 1292,

19stated, "[r]egardless of whether market manipulatio n is

achieved through deceptive trading activities or de ceptive statements as to the issuing corporation's value, i t is clear

that the essential element of the claim is that ina ccurate information is being injected into the marketplace. "

The second disputed element is whether Colkitt must establish that GFL's allegedly manipulative conduct actually depressed the prices of National Medical a nd EquiMed stock. GFL argues that market manipulation in violation of Section 10(b) and Rule 10b-5 requires that the allegedly unlawful conduct impact a security's pric e. GFL cites three cases to support its position, but all three are unhelpful. First, although we stated in Rosenberg v . Hano, 121 F.2d 818, 821 (3d Cir. 1941) (footnote omitted) , that "the party claiming injury must plead and prove som e change in price, because of the prohibited acts," t he case involved an alleged violation of Section 9, not Sec tion 10(b) and Rule 10b-5. Second, the opinion in United State s v. Russo, 74 F.3d 1383, 1394 (2d Cir. 1996), is not si gnificant here because it only addressed the propriety of the portion of the district court's jury instruction on the sci enter element that defined artificial price as the price level above the stock's actual value as determined by market fo rces. Third, the decision in In re Blech Securities Litig ation, 928 F. Supp. 1279, 1298 (S.D.N.Y. 1996) (citation omitt ed), directly contradicts GFL's position by stating that "[t]he absence of allegations of market dominance and pric e movement are not fatal to" a claim of market manipu lation, for although "these may be classic attributes of ma rket manipulation, they are not requisites."

Colkitt's position is somewhat inconsistent on this point. On the one hand, he takes great pains to argue that GFL's short sales depressed the price of National Medical by 17.5% and the price of EquiMed by 18.5%. On the oth er hand, when confronted with evidence that the prices of the stocks were on a sharp downward trend before and af ter GFL's short sales, thus raising serious doubts abou t the true reason for the declining prices, Colkitt rever ses course and argues that he need not prove that GFL's allege d scheme was successful in depressing prices. Colkitt insists that he only must establish that GFL attempted to d epress

20prices by selling shares short. To muddy the waters even

more, Colkitt appears to make a concession that an impact on price must be established when he states in his reply brief: "A jury must also decide whether GFL's short trades had an affect [sic] on share prices." Reply Br. of Appellant

at 11.

Despite his flip-flopping on the issue, Colkitt app ears to be correct that he need not prove that GFL's manipu lative conduct actually depressed prices. The Court of App eals for the Fifth Circuit concluded in Chemetron Corp. v. B usiness Funds, Inc., 718 F.2d 725, 728 (5th Cir. 1983), tha t Section 10(b), unlike Section 9(a), does not require that a plaintiff prove the allegedly unlawful activities had an effe ct on the price of the stock. Although any damages that Colki tt would be entitled to recover under his Section 10(b ) and Rule 10b-5 counterclaim would be contingent on prov ing that GFL's conduct actually depressed prices, proof of price movement is not necessary to establish a violation of Section 10(b) and Rule 10b-5 and therefore is not n ecessary to support his assertion of an affirmative defense under Section 29(b).6

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6. Although maintaining a private right of action u nder Section 10(b) requires a plaintiff to prove reliance and damages (usually reflected in the stock's price movement), Section 29(b) only req uires a violation of Section 10(b), not the maintenance of a private sui t under Section 10(b). Therefore, looking to the statutory language of the anti-fraud provision, we note that an individual violates Section 10(b)-- and therefore triggers Section 29(b) -- when he or she employs manipulativ e or deceptive devices in connection with the purchase or sale of securities. This situation is analogous to a government prosecution under Section 10(b), in which the government is not required to meet the normal standing requirements imposed on those asserting a private r emedy, inasmuch as the government need not demonstrate that the defend ant's conduct induced reliance by investors or affected the price of the security. See, e.g., United States v. Haddy, 134 F.3d 542, 549 (3d Cir. 1998) (holding

that reliance is not an element of the crime of sto ck manipulation).

Even if we were to embrace the position of GFL and the district court that proof of an effect on price is necessary to es tablish a claim of market manipulation, the district court still erred in concluding that Colkitt failed to create a genuine issue of materia l fact with respect to price movement. As already noted, Colkitt claims th at the price of

21We are satisfied that, at bottom, neither party pro perly

articulates the elements of market manipulation und er Section 10(b) in the context of a Section 29(b) aff irmative defense. Because we have not squarely addressed thi s issue, we must set forth the necessary elements for such a claim. In this regard, we conclude that to establis h a Section 29(b) affirmative defense of market manipul ation in violation of Section 10(b) and Rule 10b-5, Colkitt must present evidence that (1) in connection with the pu rchase or sale of securities, (2) GFL engaged in deceptive or manipulative conduct by injecting inaccurate inform ation into the marketplace or creating a false impression of supply and demand for the security (3) for the purp ose of artificially depressing or inflating the price of t he security.

2. Evidence Supporting Colkitt's Claim of Market Manipulation

Colkitt's affirmative defense based upon GFL's alle ged market manipulation fails because he cannot demonst rate

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National Medical dropped 17.5% and the price of Equ iMed plummeted 18.5% during the period of GFL's short sales. The d istrict court concluded, however, that these statistics are "not evidence that the value of the shares was affected by the short sales: the free fall began before

the short sales and continued well after the short sales." GFL Advantage Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and Order at 21 (M.D. Pa. July 17, 2000). The district court observ ed that the price of EquiMed declined steadily from $15.00 on February 1 , 1996, to $2.4583 on January 2, 1998, including a dramatic drop of 27 .6%, from $7.25 to $5.25, during the 24-day period immediately precedi ng GFL's short

sales. See id. at 20-21. The court also noted that National Medical plummeted from $12.875 on May 1, 1996, to $0.4375 o n January 2, 1998. See GFL Advantage, Ltd. v. Colkitt, No. 4:CV- 97-0526, Memorandum and Order at 18 (M.D. Pa. Apr. 25, 2000) . Based on these long-term, downward trends in the stocks' prices, t he district court concluded that Colkitt could not prove that GFL's s hort sales had an effect on the price of either National Medical or E quiMed stock. Although the court was correct that other factors clearly we re contributing to the slide in prices, it was not within the court's prov ince to weigh the

evidence as a finder of fact. Whether and how much GFL's alleged unlawful conduct contributed to the downturn in pri ces would have been issues for the jury if Colkitt's case had survived GFL's motion for summary judgment. Contrary to the district court's conclusion, Colkitt clearly created genuine issues as to whether GFL's short sales affected the prices of National Medical and EquiMed.

22that GFL engaged in any deceptive or manipulative c onduct

by injecting false inaccurate information into the marketplace or creating a false impression of suppl y and demand for the stock. As the district court explain ed repeatedly in its two rulings, Colkitt has not pres ented any evidence that GFL did anything but lawfully engage in short sales of National Medical and EquiMed stock. The fa ct that these short sales may have contributed to a decline in the stocks' prices is not evidence of deceptive or mani pulative conduct, for there is no reason to believe these pr ices were depressed artificially. See Sullivan & Long, Inc. v . Scattered Corp., 47 F.3d 857, 864 (7th Cir. 1995) (concluding that defendant's "unprecedented massive short selling" d id not create "a false impression of supply and demand" be cause on the other side of defendant's transactions were" real buyers, betting against [defendant], however foolis hly, that the price of [the] stock would rise"); Olympia Brew ing, 613 F. Supp. at 1296 (stating that "short selling is si mply not unlawful, even in large numbers and even if the tra ding does negatively affect the purchase price"). Indeed , the

district court stated it well when it wrote that it is

unreasonable "to infer unlawful intent from lawful activity alone." GFL Advantage Fund, Ltd. v. Colkitt , No. 4 :CV-97- 0526, Memorandum and Order at 19 (M.D. Pa. July 17, 2000).

In the cases Colkitt cites in which courts conclude d that a party's short selling was part of a scheme to man ipulate stock prices, the short selling was in conjunction with some other deceptive practice that either injected inacc urate

information into the market or otherwise artificial ly affected the price of the stock. See Russo, 74 F.3d at 1387, 1390, 1391 (defendants used short sales in concert with "unauthorized placements" and "parking" of stock in customers' accounts to generate false credits that funded their "stock-kiting scheme" designed to artificiall y inflate stock prices); United States v. Regan, 937 F.2d 823 , 829 (2d Cir. 1991) (defendants sought to depress temporaril y the price of stock by arranging to have 40,000 shares s old short secretly to a broker-dealer without disclosin g to the dealer the identity of the seller or the moving par ty behind the deal); United States v. Charnay, 537 F.2d 341, 344 (9th Cir. 1976) (to facilitate a take-over bid, defendan ts

23artificially depressed stock prices by getting othe rs to sell

86,100 shares short and "guaranteeing these sellers by secret understanding a recovery of $22 per share irrespective of the price obtained on the Exchange" ); Advanced Magnetics, Inc. v. Bayfront Partners, Inc. , No. 92 Civ. 6879 (CSH), 1996 WL 14440 (S.D.N.Y. Jan. 16, 1 996) (defendant attempted to depress stock prices throug h short sales that contravened Section 10(a) of the Exchang e Act and Rule 10a-1 thereunder, which prohibits a short sale "below the price at which the last sale" of the sec urity was reported), vacated in part on other grounds, 106 F. 3d 11 (2d Cir. 1997).

The remaining cases of market manipulation Colkitt cites likewise involved either injection of inaccurate in formation into the market or creation of a false impression o f supply and demand for a stock. See Santa Fe Indus., 430 U. S. at 467, 97 S.Ct. at 1298 (defendant obtained "fraudule nt appraisal" of stock that severely undervalued its w orth "in order to lull the minority stockholders into errone ously believing that [its cash-exchange offer] was genero us"); Crane Co. v. Westinghouse Air Brake Co., 419 F.2d 7 87, 792-93 (2d Cir. 1969) (in an effort to inflate pric es and thwart a corporate take-over, defendant "painted th e tape" by purchasing large blocks of stock in the open mar ket at inflated prices while simultaneously making large s ecret and unreported sales at lower prices to partially f inance the purchases); Blech, 928 F. Supp. at 1286, 1298 (defe ndant arranged "sham transactions" to inflate prices by improperly directing trades into and out of brokera ge accounts at the firm without the authorization of t he owners of the accounts); SEC v. Kimmes, 799 F. Supp . 852, 856-57 (N.D. Ill. 1992) (defendant maintained artif icially high stock prices by buying and selling stock throu gh "undisclosed nominee accounts," distributing"false and misleading registration statements," and filing"fal se and materially misleading period reports" with the SEC) , aff'd sub nom., SEC v. Quinn, 997 F.2d 287 (7th Cir. 1993 ); SEC v. Malenfant, 784 F. Supp. 141, 144-45 (S.D.N.Y. 19 92) (defendant arranged "matched buy and sell orders" t o "create a misleading appearance of active trading i n the Texscan common stock" and thus drive up the price o f the

24stock). Once again, Colkitt fails to proffer any ev idence that

GFL engaged in any such inappropriate conduct.

Colkitt attempts to overcome this dearth of evidenc e of deceptive or manipulative conduct on the part of GF L by claiming that short sales, by their very nature,"co nvey to market participants negative information about the prospects of the firm." Br. of Appellant at 39. Col kitt's argument misses the mark, however, because conveyin g negative information about a firm does not constitu te market manipulation unless the information is untru thful. Indeed, legitimate short sales often convey negativ e information about a company insofar as short sales suggest that a stock's price is overvalued, but that does n ot mean that such sales distort the market. To the contrary , short selling can help move an overvalued stock's market price toward its true value, thus creating a more efficie nt marketplace in which stock prices reflect all avail able

relevant information about the stock's economic val ue. See Sullivan & Long, 47 F.3d at 861-62.

Colkitt maintains that National Medical and EquiMed were not overvalued. He insists that, because GFL d id not argue before the district court that it sold short because it believed the stocks were overvalued, Colkitt is ent itled to

the inference that "the short sales were made at le ast in part to convey to the market the false impression t hat the

stocks were overvalued so as to result in a decline in share prices." Br. of Appellant at 40 (emphasis in origin al). It would not be reasonable to draw such an inference, however, for to do so would fly in the face of unco ntradicted evidence that the prices of National Medical and Eq uiMed

were on a dramatic slide before and after GFL's sho rt sales. If we were to draw any inference from the record ev idence about the value of National Medical and EquiMed, it would

be that the market considered the stocks to be over valued and that GFL simply was responding to market forces

, rather than distorting them, by engaging in short s ales.

An examination of Colkitt's other requested inferen ces,7

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7. The parties disagree about the standard of revie w that should be applied to Colkitt's requested inferences. GFL cont ends that the standard

25see Br. of Appellant at 30-35, exposes Colkitt's cl aims for

what they are -- nothing more than a general attack on the lawful practice of short selling. For instance, Col kitt's first two inferences -- that GFL had a "unique financial incentive" to depress the prices of National Medica l and EquiMed because its profits increased as the market prices decreased,8 and that short selling "conveys negativ e information" about the company being short sold and contributes to a drop in share prices -- are genera l criticisms of short selling. These inferences, even if granted, are of no help to Colkitt in trying to prove market manipulation, inasmuch as short selling is a lawful investment strategy. Colkitt's next three requested

inferences -- that GFL's short sales constituted a large percentage of shares sold on a daily basis, that GF L's short

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is abuse of discretion because Colkitt raised these inferences for the

first

time when it filed its motion for reconsideration. Colkitt maintains that the standard is plenary because he raised all of th e evidence and advanced all of the arguments at earlier stages in the litigation. This point is moot, however, because we would uphold the district court's rulings with respect to the inferences under either standard.

8. Colkitt believes that GFL's incentive to depress prices is "unique"

because the structure of the convertible notes allo ws GFL to receive more shares -- and thus higher profits -- as the stocks' prices decline. This incentive, however, is not unique to GFL's situatio n. All short sellers receive higher profits as the stock's price decline s. Indeed, these higher profits in the face of declining prices are why tra ders engage in short sales. They are betting that the stock's price will decline, and if it

does so, they will have to spend less money buying repla cement stock to cover the borrowed shares, thus allowing them to pocket t he difference.

Colkitt's differentiation between GFL and other sho rt sellers based on the structure of the National Medical and EquiMed n otes is misguided. Whether GFL acquires $100,000 worth of shares from Colkitt in exchange for debt (as GFL did here) or in exchange for cash (as short sellers normally do when they cover) is irrelevant. In either situation,

GFL will be able to obtain more shares from Colkitt if prices decline. Thus, if this "unique" incentive to depress prices is evidence that GFL engaged in market manipulation, then all short trad ers are likewise guilty of manipulating markets in violation of Sect ion 10(b). Of course, this position is untenable, for as already explaine d, short selling is perfectly lawful.

26sales caused a 17.5% decline in National Medical an d an

18.5% decline in EquiMed,9 and that these price slu mps allowed GFL to obtain an additional 11,658 shares o f National Medical and an additional 27,882 shares of EquiMed from Colkitt -- are equally unavailing. Onc e again, short selling, even in large volumes, is not in and of itself unlawful and therefore cannot be regarded as eviden ce of market manipulation. That short selling may depress share prices, which in turn may enable traders to acquire more shares for less cash (or in this case, for less deb t), is not evidence of unlawful market manipulation, for they simply are natural consequences of a lawful and carefully regulated trading practice.10

Colkitt's remaining inferences are equally groundle ss. Because a court is required to indulge only reasona ble inferences, we reject Colkitt's last three requeste d inferences. For instance, Colkitt insists that GFL' s use of

four different brokers to execute the short trades is

evidence that GFL tried to conceal its short sales from market participants, including Colkitt. This infere nce is

unreasonable as GFL needed to use four brokers beca use none of them had enough shares necessary for GFL to

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9. As already noted, see supra note 1, Colkitt grea tly exaggerates EquiMed's price decline. The price of EquiMed on th e day of the GFL's first short sale on November 8, 1996, was $5.25 per share, and its price on the day of GFL's last short sale on November 22, 1996, was $5.13. Consequently, the price of EquiMed dipped only $.12 , or 2.3%.

10. A passage in Colkitt's reply brief further unde rmines his theory that short sales are manipulative because they depress p rices. He writes: "It

is reasonable and makes economic sense to infer tha t short selling drives down share prices, because each short sale is, itse lf, a `sale,' increasing supply . . . ." Reply Br. of Appellant at 15 (empha sis added). In other words, Colkitt believes that short sales are manipu lative because they increase the stock's supply and drive down its pric e. This, of course, is true (assuming demand remains constant), but it is also true for all stock sales, whether they are from long positions o r short positions. The rationale of Colkitt's theory would lead to the abs urd result of outlawing any sales practice that increases a security's supp ly and consequently may affect its price. Colkitt fails to understand t hat increasing the supply of stocks by selling them on the open market in legitimate transactions to real buyers does not artificially a ffect prices and

therefore cannot be manipulative.

27borrow to carry out all of its short sales, which i s not

unusual when dealing with small cap stocks. See Br . of Appellee at 39 (citing Cason Aff. P 13 (App. 001080 )).

Colkitt's next requested inference relates to GFL's assertion that it sold National Medical and EquiMed short to hedge against the stocks' declining prices and t o lock in the notes' 17.5% and 18.5% profit spreads. Colkitt offers expert testimony that GFL's short sales could not h ave been part of a legitimate hedging strategy because too m uch time elapsed between the short sales and the exchange demands. The expert avers that if GFL were only try ing to protect itself against declining prices after it ma de its exchange demand, it could have eliminated that "del ivery risk" by selling short during the five-day period b efore the exchange demand, thus locking in the sale price dur ing the same period the average closing price would be dete rmined. Because GFL waited so long after the short sales to make its exchange demands, the expert contends GFL was n ot simply hedging against slumping prices, but was "increas[ing] the likelihood of increasing profits through artificially (and temporarily) lowering the price o f EquiMed."11 Br. of Appellant at 16-17 (quoting Expert Report of Professor Steven R. Grenadier P 20. (App. 000860-00 0861)).

Accepting as true Grenadier's position that GFL cou ld have hedged against all risk by selling short durin g the fivedays prior to the exchange demands, a court reasona bly could infer that GFL not only sought to protect its elf, but also endeavored to reap further profit from the sto cks' declining prices by selling short. To infer that th ese "premature" short sales were executed to manipulate prices, however, would be an unreasonable leap. Ind eed, Grenadier admits in his deposition that he does not have an opinion about whether GFL's short sales artifici ally depressed the prices of EquiMed stock. See Grenadie r Dep. at 37 (App. 001016). Therefore, although it may be reasonable to infer from Grenadier's report that GF L's short

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11. Grenadier mentions only EquiMed because GFL sol d National Medical short during the five-day period prior to i ts exchange demands to the stock. Therefore, even under Grenadier's the ory, GFL's short trades of National Medical qualify as a legitimate hedging strategy.

28sales were intended not only to hedge against decli ning

prices but to profit from them, it would be unreaso nable to infer that GFL's short sales were deceptive or mani pulative, especially considering that the expert concedes tha t he does know whether the trades had the effect of manipulat ing the prices.12

Finally, in the words of the district court, Colkit t's last requested inference amounts to "baseless and desper ate mudslinging." Colkitt asserts that GFL was sued twi ce "for engaging in manipulative short selling" thus eviden cing that it engaged in that type of conduct with regard Nati onal Medical and EquiMed stock. Br. of Appellant at 35. GFL responds that it was not even involved in Global In tellicom, Inc. v. Thomson Kernaghan & Co., No. 99-CIV-342, 19 99 WL 544708 (S.D.N.Y. July 27, 1999). Instead, the ca se involved a former employee whose allegedly unlawful

conduct occurred after he left GFL. GFL also assert s that the action in JTS Corp. v. GFL Advantage Fund, Ltd. was dismissed in the early stages of the litigation aft er it filed for Rule 11 sanctions against the plaintiff. Based on GFL's averments, it would be entirely inappropriate to gr ant Colkitt's requested inference that these two lawsui ts are evidence of GFL's alleged market manipulation in th is case.

At bottom, the core of Colkitt's argument is premis ed on his belief that short selling artificially depresse s prices and presumably should be banned as a market manipulatio n. Unfortunately for Colkitt, however, short selling i s lawful, and courts have held that short selling, even in ma ssive volume, is neither deceptive nor manipulative when carried out in accordance with SEC rules and regulations. S ee

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12. Other portions of Grenadier's report also appea r to undermine such a conclusion. In particular, Grenadier endorses the conclusions of Harvard Business School's Paul Asquith and Lisa Meu lbroek that short trading would have an impact on the value of the se curities if the

number of shares sold short constituted 2.5% or mor e of the total outstanding shares. See Grenadier Dep. at 80-81 (Ap p. 001017-001018). In this case, GFL sold short a total of 78,700 shar es of EquiMed, which constituted only .275% of EquiMed's 28,589,717 outs tanding shares. Therefore, under the standard embraced by Colkitt's own expert, GFL's short sales of EquiMed stock would not be expected to have a noticeable impact on the stock's price.

29Sullivan & Long, 47 F.3d at 864-65. Therefore, to m ake out

a claim of market manipulation, Colkitt must presen t evidence that GFL engaged in some other type of dec eptive behavior in conjunction with its short selling that either injected inaccurate information into the marketplac e or created artificial demand for the securities. Colki tt has offered nothing but evidence that GFL engaged in la wful short sales of National Medical and EquiMed, which alone is insufficient to prevail on a claim of market man ipulation in violation of Section 10(b) and Rule 10b-5.

Another reason why Colkitt's market manipulation cl aim fails is because he has not met the scienter requir ement by offering evidence that GFL engaged in short sales f or the purpose of artificially depressing the prices of Na tional Medical and EquiMed stock. Citing our opinion in In re Advanta Corp. Securities Litigation, 180 F.3d 525, 535 (3d Cir. 1999), Colkitt argues that he has met the reck lessness standard for liability under Section 10(b). He cont ends that GFL's conduct constitutes "an extreme departure fro m the standards of ordinary care" and "presents a danger of misleading buyers and sellers that is either known to the

defendant or is so obvious that the actor must have been aware of it." Id. (internal quotation marks omitted ). According to Colkitt, evidence of GFL's alleged rec klessness includes: GFL's "powerful economic incentive" to de press the stocks' prices; "voluminous scholarly evidence" that GFL's short sales would convey a "negative impressi on" of the companies; the dramatic drop in the stocks' pri ces during the period of GFL's short selling; the addit ional 39,540 shares that GFL "extracted" from Colkitt bec ause of the declining prices; GFL's use of four brokers to conceal his short sales; the conclusion of Colkitt's expert that GFL's short sales were not part of a legitimate hedging s trategy; and GFL's having been sued twice for similar conduc t.

In essence, Colkitt recycles his arguments that he advanced in support of his contention that GFL's sh ort trades were manipulative and deceptive. Some of thi s evidence and the requested inferences to be taken therefrom already have been discredited -- GFL's us e of multiple brokers, whether GFL's short sales were a legitimate hedge strategy, and the alleged lawsuits against

30GFL for engaging in short selling -- and the rest o f the

evidence and inferences are, once again, general at tacks on the practice of selling short -- the powerful incen tive to depress prices, the negative impression of the comp any conveyed by short sales, the actual drop in Nationa l Medical and EquiMed prices, and the additional shar es GFL obtained because of the declining prices. All that this information proves is that GFL engaged in the lawfu l practice of selling stock short and that these shor t sales may or may not have affected the price of National Medical and EquiMed stock. This evidence neither establishe s that GFL's short sales were manipulative nor demonstrate s that GFL executed the trades for the purpose of depressi ng the stocks' prices. Perhaps, if Colkitt had offered evi dence that GFL's short sales violated SEC rules (for instance, if GFL failed to cover properly the short sales in violati on of Rule 10a-2, or if GFL made short sales below the last sa les price in violation of Rule 10a-1), Colkitt might have bee n able to establish that GFL's conduct was intentionally or r ecklessly manipulative or deceptive. In the absence of eviden ce that GFL engaged in any wrongful conduct, however, Colki tt's claim of market manipulation must fail. Therefore, we will affirm summary judgment in favor of GFL with respec t to the market manipulation claim.

C. SECURITIES FRAUD

Colkitt also claims that the notes should be voided pursuant to Section 29(b) on the grounds that GFL

committed securities fraud in violation of Section 10(b) and

Rule 10b-5 when it failed to disclose its intent to manipulate the prices of National Medical and EquiM ed stock through short sales. GFL responds that it had no duty to disclose its intent to engage in short sale s and that

Colkitt has not established that he either relied o n this alleged omission of fact or suffered a cognizable i njury as a

result of the reliance.

1. Elements of Securities Fraud Under Section 10(b) and

Rule 10b-5

It is well settled that a claim of securities fraud under Section 10(b) requires proof "that the defendant (1 ) made misstatements or omissions of material fact; (2) wi th

31scienter; (3) in connection with the purchase or sa le of

securities; (4) upon which plaintiffs relied; and ( 5) that plaintiffs' reliance was the proximate cause of the ir injury." Weiner v. Quaker Oats Co., 129 F.3d 310, 315 (3d Ci r. 1997) (citation and internal quotations omitted). T he parties apparently agree that the third element has been established, as there is no dispute that the allege d fraud was related to the purchase or sale of National Med ical and EquiMed securities. Therefore, Colkitt must establi sh genuine issues with respect to the following elemen ts: omissions of material fact, reliance, cognizable in jury, and

scienter.13

2. Evidence Supporting Colkitt's Claim of Securitie s Fraud

Colkitt asserts that GFL concealed from him two cri tical pieces of information that constitute omissions of material fact: (1) GFL's intention to sell short National Me dical and EquiMed stock; and (2) GFL's actual short sales of the

stock. Colkitt maintains that GFL had an affirmativ e duty

to disclose this information because it was materia l and he

would not have entered into the contracts with GFL if he had known it planned to sell the stocks short.

Analysis of a securities fraud claim under Section 10(b) and Rule 10b-5 includes two steps: "First, was the defendant under a duty to disclose at the time at i ssue? Second, was the alleged omission or misstatement material? If, under the facts of this case, no duty to disclose exists, or if the undisclosed facts are not materia l, there is no liability under Rule 10b-5." Staffin v. Greenber g, 672 F.2d 1196, 1202 (3d Cir. 1982). A duty to disclose arises only when one party to a transaction has material information that the other party is entitled to hav e because of some relationship of trust and confidence betwee n the parties, such as when one party is a fiduciary, cor porate insider, or "tippee." See Chiarella v. United State s, 445 U.S. 222, 229, 100 S.Ct. 1108, 1115 (1980). The Supreme Court has determined that "[a]n omission of fact is mater ial if

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13. Colkitt submits the same evidence of scienter i n support of both his securities fraud claim and his market manipulation claim. See supra pp.

30-31.

32there is a substantial likelihood that a reasonable

shareholder would consider it important in deciding " whether to invest. Basic, Inc. v. Levinson, 485 U.S . 224, 231, 108 S.Ct. 978, 983 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449, 96 S.Ct. 2126, 2 132 (1976)). Materiality is a mixed question of law and fact and should be decided as a matter of law "[o]nly when t he disclosures or omissions are so clearly unimportant that

reasonable minds could not differ." In re Craftmati c Sec. Litig., 890 F.2d 628, 641 (3d Cir. 1990).

Colkitt's securities fraud claim falters for at lea st one and possibly two reasons. To start with, he failed to p resent any evidence that GFL intended to engage in short sales at the time it loaned the money to Colkitt. See In re Phil lips Petroleum Secs. Litig., 881 F.2d 1236, 1245 (3d Cir . 1989) (stating that "a statement of intent need only be t rue when made; a subsequent change of intention will not, by itself, give rise to a cause of action under Section 10(b) or Rule 10b-5"). More significantly, even if we can draw an inference that GFL had such a plan, it did not have a duty

to disclose its intentions.

Colkitt argues that GFL had a duty to disclose its intentions because such a disclosure was necessary to clarify GFL's "implicit" representations that the d ebt-forstock exchange price would be "based upon the accur ate, unbiased and untainted market price quoted by the s tock market." Br. of Appellant at 48. Colkitt explains t hat Section 10(b) and Rule 10b-5 impose a "duty to disc lose any material facts that are necessary to make discl osed material statements, whether mandatory or volunteer ed, not misleading." Craftmatic, 890 F.2d at 641. He as serts that GFL's implicit guarantee that the exchange pri ce would be based upon prevailing market forces "was rendere d grossly misleading by GFL's failure to disclose tha t it intended to short sell EquiMed and National Medical ." Br. of Appellant at 48-49.

We must reject Colkitt's argument for it is premise d on the misguided notion that short sales distort marke ts and thus produce inaccurate, biased, and tainted market prices. As already explained, short sales executed in accor dance with SEC rules and regulations not only are lawful, but also

33do not distort markets or create a false impression of

supply and demand because they are legitimate transactions with real buyers on the other side of the sale who are betting that the stock's price will rise. S ee Sullivan & Long, 47 F.3d at 864. Contrary to Colkitt's asser tion, GFL's short sales did not render its guarantee misl eading, and GFL consequently did not have a duty to disclos e to Colkitt its intention to engage in short selling. T herefore, because Colkitt failed to create a genuine issue wi th respect to GFL making an omission of material fact, we will affirm summary judgment in favor of GFL with respect to th e securities fraud claim.

D. REINSTATEMENT OF FEDERAL SECURITIES LAW

COUNTERCLAIMS

Colkitt argues that the district court erred when i t dismissed his amended counterclaims for lack of spe cificity on February 2, 1999. He simply states that he pled his amended counterclaims, which span 30 pages, with sufficient specificity pursuant to Fed. R. Civ. P. 9. We need not consider these contentions, however, because, a s we have explained, Colkitt failed to create genuine is sues of material fact as to certain elements of his corresp onding affirmative defenses, and thus, his counterclaims m ust fail

on the merits as well.

E. VIOLATIONS OF PENNSYLVANIA LAWS

1. Securities Claims

Section 1-508 of the Pennsylvania Securities Act ba rs the basing of certain suits on contracts that violate s tate securities laws. See Pa. Stat. Ann. tit. 70,S 1-508 (1994). Section 1-401 of the Pennsylvania Securities Act pr ohibits the use of any "device, scheme or artifice to defra ud" and the omission of any "material fact necessary in ord er to make statements made, in light of the circumstances under which they were made, not misleading." Id. S 1-401 (a), (b). Finally, Pennsylvania common law permits "[t]he rec ipient of a misrepresentation [to] avoid the contract by s howing that the misrepresentation was either fraudulent or material." Germantown Mfg. Co. v. Rawlinson , 491 A .2d 138, 141 (Pa. Super. Ct. 1985). As GFL asserts, the se provisions are "functionally identical" to Section 29(b) and

34Section 10(b) of the Exchange Act. See Rosen v.

Communication Serv. Group, Inc., 155 F. Supp. 2d 31 0, 321 n.14 (E.D. Pa. 2001) ("Section 401 of the Pennsylva nia

Securities Act is modeled after Rule 10b-5 of the f ederal securities laws, and requires virtually the same el ements of proof."). Therefore, Colkitt's state securities and common law fraud claims fail for the same reasons his fede ral

securities claims fail.

2. Breach of Contract Claim

Colkitt argues that GFL is barred under Pennsylvani a law from enforcing the notes because GFL committed a ma terial breach of the contracts by refusing to accept Colki tt's prepayment, even though the notes contain no langua ge prohibiting prepayment. Colkitt claims that he noti fied GFL in late December 1996 and early January 1997 that h e would prepay all outstanding principal and interest on the notes, but GFL improperly rejected Colkitt's reques t for prepayment in hopes of declaring the notes in defau lt and collecting millions of dollars in penalties.

GFL responds that it did not outright reject Colkit t's request for prepayment, but conditionally accepted the prepayment offer while reserving its rights to disp ute the balance due. GFL not only disagreed with Colkitt ab out the amounts due, but refused to allow Colkitt to dictat e the terms of any prepayment. Because of its conditional acceptance of Colkitt's offer, GFL maintains that w hether or not the notes permitted prepayment is not at issue. 14 GFL also argues that Colkitt's failure to tender any pr epayments -- or any payments, for that matter -- undermines h is position that he was attempting to make a full prep ayment of outstanding principal and interest.

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14. The district court, responding to Colkitt's ass ertion that the notes

do not permit GFL either to reject or accept condition ally an offer of prepayment, stated that "nothing in the agreements requires GFL to accept prepayment in an amount unilaterally imposed by Colkitt." GFL Advantage Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and Order at 24 (M.D. Pa. Apr. 25, 2000). Thus, the cou rt concluded that "GFL's acceptance while reserving its rights to the disputed amount does

not constitute a breach of contract." Id.

35More importantly, however, Colkitt admitted that he was

in material breach of his obligations on the notes before his first prepayment offer. In particular, he was in de fault on his interest obligations, he failed to maintain a p ledge of securities in escrow, and he neglected to file requ ired disclosure documents with the SEC. See Colkitt Dep. at 272-73, 261-62, 195-97 (App. 000581-000582, 000577- 000578, 000552-000554). In light of these prior bre aches, the district court did not err in granting summary judgment

in favor of GFL on its breach of contract claim.

F. DAMAGES

The district court granted GFL damages in the amoun t of $21,121,989.39. Colkitt argues that the damages sho uld be limited to principal and interest outstanding as of the date of his prepayment request, which would reduce the damages to $11,740,198.

First, Colkitt believes that GFL forfeited its righ t to collect anything but principal and interest when it rejecte d Colkitt's prepayment offer. As already addressed, h e maintains that GFL's refusal to accept prepayment

constituted a breach of contract and that if GFL ha d accepted his prepayment offer as it allegedly was o bligated to do, he would have owed only $11,740,198. Colkitt cannot prevail on this argument, however, as he nev er actually tendered the $11,740,198 prepayment. Depri ving GFL of the interest and penalties due on a balance that Colkitt never paid would reward him unfairly for hi s breach by allowing him to hold onto GFL's money interest f ree for nearly four and a half years.

Second, Colkitt argues that GFL is prohibited from recovering both the 20.5%/22% "premium" and the 14% "default interest" because they constitute an unenf orceable penalty "that is disproportionate to the value of t he performance promised or the injury that has actuall y occurred." Br. of Appellant at 64 (quoting Finkle v . Gulf & Western Mfg. Co., 744 F.2d 1015, 1021 (3d Cir. 1984 )). Colkitt claims that the "premiums" exceed the profi t GFL would have been able to earn had it exchanged all o f the debt for shares of National Medical and EquiMed and sold

the shares on the market. He also insists that addi ng 14%

36"default interest" to the premiums is simply puniti ve and

constitutes unenforceable liquidated damages.

We reject Colkitt's request to reduce the damage aw ard. Both the "premiums" and the "default interest" comp ensate GFL for distinct economic losses suffered by GFL as a result of Colkitt's breach. The 20.5% and 22% "prem iums" represent the grossed-up value of the 17% and 18% discounts guaranteed in the notes. The premiums are intended to restore GFL to the position where it wo uld have

been if GFL had been able to convert all of the deb t into National Medical and EquiMed stock. In contrast, th e "default interest" is intended to compensate GFL fo r damages it incurred since Colkitt's breach -- namel y, the deprivation of its money over the past four and a h alf years. Not only were these provisions included in contract s that were negotiated at arm's length, but contrary to Co lkitt's assertions, they also would restore GFL to the posi tion that

it would have held if Colkitt had not breached the notes.

IV. CONCLUSION

For the foregoing reasons, we will affirm the order s of the district court entered on April 25, 2000, and July 17, 2000.

A True Copy:

Teste:

Clerk of the United States Court of Appeals

for the Third Circuit

37