Source: http://in.findacase.com/research/wfrmDocViewer.aspx/xq/fac.20180323_0000414.SIN.htm/qx
Timestamp: 2019-03-25 10:27:36
Document Index: 488401987

Matched Legal Cases: ['§ 78', '§ 240', '§ 78', '§ 77', '§ 78', '§ 240', '§ 240', '§ 240', '§ 78', '§ 240', '§ 78', '§ 7243', '§ 78', '§ 10', '§ 10', '§ 17', '§ 17', '§ 10', '§ 10', '§ 10', '§ 10', '§ 10', '§ 10', '§ 10', '§ 10', '§ 10', '§ 240', '§ 10', '§ 10', '§ 10']

ITT Educational Services, Inc., Kevin M. Mod any, and Daniel M. Fitzpatrick, Defendants.
Plaintiff United States Securities and Exchange Commission (the "SEC") initiated this litigation against ITT Educational Services, Inc. ("ITT"), Kevin Modany, and Daniel Fitzpatrick in May 2015, alleging that Defendants violated various federal securities laws in connection with two student loan programs created by ITT for ITT students. Specifically, the SEC alleges that when the loan programs exhibited high default rates and ITT's guarantee obligations increased, Defendants engaged in various deceptive acts to conceal the condition of the loan programs and the impact on ITT's financial condition. The SEC and ITT reached a settlement, but claims against Mr. Modany and Mr. Fitzpatrick remain pending. Both the SEC on the one hand, and Mr. Modany and Mr. Fitzpatrick on the other, have filed Motions for Partial Summary Judgment, [Filing No. 225; Filing No. 227], which are now ripe for the Court's decision.
In deciding a motion for summary judgment, the Court need only consider disputed facts that are material to the decision. A disputed fact is material if it might affect the outcome of the suit under the governing law. Hampton v. Ford Motor Co., 561 F.3d 709, 713 (7th Cir. 2009). In other words, while there may be facts that are in dispute, summary judgment is appropriate if those facts are not outcome determinative. Harper v. Vigilant Ins. Co., 433 F.3d 521, 525 (7th Cir. 2005). Fact disputes that are irrelevant to the legal question will not be considered. Anderson v. Liberty 10bby, Inc., 477 U.S. 242, 248 (1986).
"The existence of cross-motions for summary judgment does not. . . imply that there are no genuine issues of material fact." R.J. Corman Derailment Servs., LLC v. Int'l Union of Operating Eng'rs, 335 F.3d 643, 647 (7th Cir. 2003). Specifically, "[p]arties have different burdens of proof with respect to particular facts, different legal theories will have an effect on which facts are material; and the process of taking the facts in the light most favorable to the non-movant, first for one side and then for the other, may highlight the point that neither side has enough to prevail without a trial." Id. at 648.
The following factual background is set forth pursuant to the standard discussed above. The facts stated are not necessarily objectively true, but as the summary judgment standard requires, the undisputed facts and the disputed evidence are presented in the light most favorable to "the party against whom the motion under consideration is made." Premcor USA, Inc. v. American Home Assurance Co., 400 F.3d 523, 526-27 (7th Cir. 2005).
ITT was a for-profit higher education company whose stock was registered with the SEC and quoted on the New York Stock Exchange. [Filing No. 1 at 5; Filing No. 33 at 2.][1]Mr. Modany was ITT's Chief Executive Officer ("CEO") since 2007, and chairman of its Board of Directors since 2008. [Filing No. 1 at 5-6; Filing No. 33 at 3.] Mr. Modany served as ITT's President and Chief Operating Officer ("COO") from 2005 to 2007, and was Chief Financial Officer ("CFO") from 2003 to 2005. [Filing No. 1 at 6; Filing No. 33 at 3.] Mr. Fitzpatrick was ITT's CFO, principal accounting officer, and Executive Vice President since April 2009. [Filing No. 1 at 6-7; Filing No. 33 at 3.] Both Mr. Modany and Mr. Fitzpatrick played a role in ITT's disclosure process, including editing portions of, and reviewing, signing, and certifying ITT's periodic filings. [Filing No. 1 at 6-7; Filing No. 1 at 26; Filing No. 1 at 31; Filing No. 1 at 34; Filing No. 33 at 3-4; Filing No.33 at 13; Filing No. 33 at 15-17.]
B. The PEAKS Program
In 2010, ITT formed the Program for Education Access and Knowledge student loan program (the "PEAKS Program"). [Filing No. 1 at 1; Filing No. 1 at 9.] It was structured as a trust (the "PEAKS Trust") that raised funds by issuing senior debt to institutional investors (the "PEAKS Noteholders"). [Filing No. 1 at 9.] The PEAKS Trust received the cash flows generated by payments on the student loans and used those funds to pay the principal and interest of the senior debt, and other fees and expenses. [Filing No. 1 at 9.] A student loan servicer collected payments on the student loans. [Filing No. 1 at 9.]
ITT made certain guarantees related to the PEAKS Program, including all of the principal and interest payments on the PEAKS senior debt, other financial obligations of the PEAKS Trust, and maintaining a "parity ratio" between the PEAKS Trust's assets (the value of the loans made to ITT's students) and liabilities (the senior debt owed to the PEAKS Noteholders). [Filing No. 1 at 9.] If ITT failed to make the required guarantee payments on time, the PEAKS Noteholders could force ITT to immediately pay the entire amount of principal and interest remaining on the senior debt in advance of the 2020 maturity date. [Filing No. 1 at 10.]
C. The CUSO Program
In 2009, ITT launched the Credit Union Service Organization student loan program (the "CUSO Program"). [Filing No. 1 at 10.] The CUSO Program involved a group of credit unions, acting through a Credit Union Service Organization ("CUSO"), making a total of approximately $141 million in private loans to ITT students. [Filing No. 1 at 10.] Loans made in each year of the CUSO Program were aggregated into one of three annual loan pools. [Filing No. 1 at 10.] ITT and the CUSO entered into a risk sharing agreement whereby if more than 35% of the loans in any of the three annual pools defaulted, ITT guaranteed payment of the principal, interest, and fees on any loans that defaulted over the 35% threshold (the "risk share threshold"). [Filing No. 1 at 10.] Once ITT's guarantee obligation was triggered for one of the CUSO loan pools, ITT could either pay the monthly payments due on defaulted loans over the threshold (a minimum payment), or discharge its total future obligation by immediately paying the outstanding principal plus some additional interest. [Filing No. 1 at 10-11.]
D. The Allegedly Fraudulent Scheme
From the end of 2011 through the end of the third quarter of 2012, loans through the PEAKS Program and the CUSO Program were defaulting at high rates. [Filing No. 1 at 12.] At the same time, ITT's financial performance and stock price were declining due to, among other issues, decreasing enrollment at ITT. [Filing No. 1 at 12.] In October 2012, ITT received a demand for a PEAKS guarantee payment of more than $8 million due to the parity ratio falling below its required level. [Filing No. 1 at 14.] ITT made a payment to the PEAKS Trust for $8 million. [Filing No. 1 at 14.] Mr. Modany and Mr. Fitzpatrick then began devising a plan to avoid PEAKS Program guarantee payments. [Filing No. 1 at 14.]
The alleged scheme involved ITT determining which students were about to default on their loans, and making the minimum payment necessary to avoid default on their behalf, without advising the students that these payments were being made. [Filing No. 1 at 15.] These "Payments on Behalf of Borrowers" ("POBOB") were to prevent PEAKS Program loans from defaulting so that ITT could avoid making parity ratio guarantee payments. [Filing No. 1 at 15.] At the end of October 2012, ITT made approximately $2.4 million in POBOB payments, which allowed ITT to avoid approximately $30 million in guarantee payments to the PEAKS Trust. [Filing No. 1 at 15.] Neither ITT, Mr. Modany, nor Mr. Fitzpatrick disclosed POBOB to investors. [Filing No. 1 at 16.]
As for the CUSO Program, ITT calculated its liability for CUSO guarantee payments (triggered when loans defaulted over a 35% risk share threshold), and determined to pay the monthly minimum. [Filing No. 1 at 28.] Defendants did not disclose to investors in public filings that the method ITT used to calculate liability - which assumed that ITT would immediately discharge its obligation - was inconsistent with the method ITT actually used to pay its CUSO guarantee - which was to make minimum payments of the monthly amounts due on the high-interest loans. [Filing No. 1 at 29.] The decision to make only the monthly minimum payments resulted in increasing the amount that ITT would ultimately have to pay on the CUSO guarantee well beyond the amount of the liability disclosed in public filings. [Filing No. 1 at 28-29.]
The SEC initiated this litigation in May 2015, alleging that Mr. Modany and Mr. Fitzpatrick, among other things:[2]
• "Designed ITT's off-balance sheet student loan programs";
• "Devised and implemented the POBOB payment practice, which had the effect of temporarily delaying significant and looming PEAKS guarantee payments";
• "Failed to disclose the POBOB practice to investors";
• "Initially concealed the POBOB practice from the PEAKS Noteholders";
• "Misrepresented to ITT's auditor that the PEAKS Noteholders had consented to the POBOB practice when in fact they were not initially consulted about the practice and, when they did learn of the practice, objected to it";
• "Withheld from ITT's auditor that ITT had received a legal opinion that POBOB payments were likely not permitted under the terms of the PEAKS agreements";
• "Failed to disclose to ITT's auditor that ITT was projecting more than $100 million in CUSO payments if it continued using the minimum monthly payment method";
• "Failed to consolidate the PEAKS program into ITT's financial statements, even when [they] knew that ITT had the right to kick-out the PEAKS servicer";
• "Signed management representation letters to ITT's auditor that contained false or misleading statements and omissions";
• "Made false and misleading statements and omissions on earnings calls that, among other things, failed to disclose the POBOB practice and misled investors by claiming that ITT's net PEAKS liability was equal to the total amount of cash payments ITT would be required to make, when in fact ITT was projecting near-term cash payments that were tens of millions of dollars greater [than] the total net liability"; and
• "Signed or certified numerous of ITT's period[ic] filings containing material misstatements and omissions regarding PEAKS and CUSO."
[Filing No. 1 at 38-40.]
The SEC asserts the following claims against Mr. Modany and Mr. Fitzpatrick: (1) fraud under Section 10(b) of the Exchange Act and Rule 10b-5 (15 U.S.C. § 78j(b) and 17 C.F.R. § 240.10b-5); (2) control person liability under Section 20(a) of the Exchange Act (15 U.S.C. § 78t(a)) for ITT's violations of Section 10(b) and Rule 10b-5; (3) aiding and abetting ITT's violations of Section 10(b) and Rule 10b-5; (4) fraud in the offer or sale of securities in violation of Section 17(a) of the Securities Act (15 U.S.C. § 77q(a)); (5) aiding and abetting ITT's violations of Section 17(a); (6) falsified books, records, or accounts under Section 13(b)(5) of the Exchange Act and Rule 13b2-1 (15 U.S.C. § 78m(b)(5) and 17 C.F.R. § 240.13b2-1); (7) false certifications under Rule 13a-14 of the Exchange Act (17 C.F.R. § 240.13a-14); (8) deceit of auditors under Rule 13b2-2 of the Exchange Act (17 C.F.R. § 240.13b2-2); (9) aiding and abetting ITT's false SEC filings under Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a- 13 (15 U.S.C. § 78m(a) and 17 C.F.R. §§ 240.12b-20, 240.13a-1, 240.13a-11, and 240.13a-13); (10) control person liability for ITT's false SEC filings under Section 20(a) of the Exchange Act; (11) aiding and abetting ITT's violations of Section 13(b)(2) of the Exchange Act (15 U.S.C. § 78m(b)(2)); (12) control person liability under Section 20(a) of the Exchange Act for ITT's violations of Section 13(b)(2); and (13) failure to reimburse under Section 304(a) of the Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7243(a). [Filing No. 1 at45-55.]
The SEC seeks an injunction permanently enjoining Mr. Modany and Mr. Fitzpatrick from violating any securities laws, an order prohibiting either from acting as an officer or director of any public company, an order that each disgorge any ill-gotten gains, an order requiring them to pay a civil penalty, and an order requiring them to reimburse ITT for any bonuses, incentive-based and equity-based compensation, and any profits realized from their sale of ITT stock. [Filing No. 1 at 55-56.]
The Court notes at the outset the somewhat unusual nature of the pending Motions for Summary Judgment. The SEC's motion focuses on certain elements of the claims it asserts[3] and on some defenses it believes Mr. Modany and Mr. Fitzpatrick will rely upon, presumably attempting to narrow its burden of proof for trial. Mr. Modany and Mr. Fitzpatrick's motion addresses some of those elements, but also seeks to exclude certain allegations, likely to whittle away at the scheme the SEC alleges existed. The Court has done its best to align the parties' arguments with the claims, and finds that the most efficient way to address the motions is to set forth the elements of each claim[4] and then discuss each motion for summary judgment as it relates to that claim. While the result involves some repetition, the Court considered it necessary to ensure a complete analysis.
A. Claim One - Fraud Under Section 10(b) of the Exchange Act
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange - .. .To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered.. .any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
15 U.S.C. § 78j(b). In order to prove a violation of § 10(b) of the Exchange Act, the SEC must show that defendants: "(1) made a material misrepresentation or a material omission as to which [they] had a duty to speak, or used a fraudulent device; (2) with scienter; (3) in connection with the purchase or sale of securities." SEC v. Bauer, 723 F.3d 758, 768-69 (7th Cir. 2013) (quotations omitted).
2. The SEC's Motion for Summary Judgment
The SEC moves for summary judgment on two elements of its § 10(b) claim - first, that the violation occurred "by use of the means or instrumentalities of interstate commerce, or of the mails, or of a facility of a national securities exchange, " and second, that the violation occurred in connection with the purchase or sale of securities. The SEC also argues that Defendants may not rely on advice of counsel as a defense to the fraud-related claims. The Court addresses each argument in turn.
The SEC argues that it has alleged that Mr. Modany and Mr. Fitzpatrick made misstatements or omissions in public filings made with the SEC, failed to consolidate the PEAKS Trust into ITT's financial statements, and made misstatements or omissions in conference calls with investors. [Filing No. 226 at 20.] It asserts that it "is not moving for summary judgment on whether these violations occurred... [, r]ather the [SEC] is moving for judgment that, if these violations occurred, they occurred through the use of interstate commerce." [Filing No. 226 at 20.] The SEC argues that these acts were done through the use of interstate commerce because misstatements or omissions made in public filings with the SEC and misstatements or omissions made in telephone calls constitute the use of interstate commerce, and ITT was a publicly traded company using the New York Stock Exchange. [Filing No. 226 at 21.]
Buried in a footnote in Defendants' Statement of Material Facts In Dispute section of their response brief, Defendants state that "[t]he SEC moved for judgment that certain conduct (enumerated in three prongs in its brief [and related to certain public filings and conference calls]) met the interstate commerce elements of §§ 17(a) and 10(b).... As to §§ 17(a) and 10(b), Defendants do not contest interstate commerce based on the conduct described in these three prongs. Defendants understand the SEC's first and second prongs to be premised on alleged false or misleading statements in the Form 10-Q for the third quarter...2012, the Forms 10-Q for Ql-Q3 2013, and in the 2012 Form 10-K." [Filing No. 254 at 6, n. 1.]
Because Defendants concede the interstate commerce element for conduct related to certain filings and to conference calls, the Court GRANTS the SEC's Motion for Summary Judgment on that issue related to those filings and conference calls. The Court notes the SEC's representation in its opening brief that it "reached out to Defendants to ask if they would stipulate" to certain elements including the interstate commerce elements, but that Defendants were "unable to do so." [Filing No. 226 at 8, n. 1.] As trial approaches in this case, which involves numerous claims each with multiple elements, the Court encourages and expects the parties to reach as many stipulations as possible to conserve time and judicial resources. [See Filing No. 72 at 10 (Court's Practices and Procedures stating "stipulations of fact[ ] are not only encouraged but expected").]
b. In Connection With the Purchase or Sale
The SEC argues that "[misrepresentations in documents such as public filings and press releases, which are designed to reach investors and to influence their decisions to transact in a publicly-traded security meet the 'in connection with the purchase or sale' requirement" of § 10(b). [Filing No. 226 at 21.] It then points to its allegations in the Complaint, including misstatements or omissions in public filings made with the SEC and in earnings calls, which it asserts were "designed to reach investors and to influence investors' decisions related to ITT securities." [Filing No. 226 at 22.]
Mr. Modany and Mr. Fitzpatrick respond that the SEC cannot demonstrate that the "connection" between the alleged misrepresentations and the purchase or sale of securities was material and, in fact, has not argued that that is the case. [Filing No. 254 at 17.]
In its reply, the SEC argues that Mr. Modany and Mr. Fitzpatrick have "conflate[d] the materiality element [of a § 10(b) claim] (which the SEC has not moved on) with the 'in connection' element on which the SEC has moved." [Filing No. 257 at 7.]
The SEC's request for summary judgment on the issue of whether the allegedly violative acts occurred in connection with the purchase or sale of securities is based solely on the allegations of the Complaint. Indeed, the SEC cites only to the Complaint in support of its argument, and not to any evidence. In other words, the SEC asks the Court to find that if it proves certain facts at trial, then summary judgment is appropriate on the offer or sale of securities element of its § 10(b) claim. This the Court cannot do.
Federal Rule of Civil Procedure 56 provides that "[a] party may move for summary judgment, identifying each claim or defense - or the part of each claim or defense - on which summary judgment is sought. The court shall grant summary judgment if the movant shows that there is no genuine issue as to any material fact and the movant is entitled to judgment as a matter of law." Fed.R.Civ.P. 56(a). Here, the SEC has not provided material facts, supported by citations to the record, which show that the allegedly violative acts occurred in connection with the purchase or sale of securities. Rather, it has merely pointed to its allegations and has argued that if it proves those allegations are true at trial, then those facts would show that the violations occurred in connection with the purchase or sale of securities.
ITT admits some of the allegations on which the SEC relies, but those allegations do not provide the requisite connection between the purchase or sale of a security and the allegedly fraudulent acts. See U.S. v. Durham, 766 F.3d 672, 682 (7th Cir. 2014) (the "in connection with the purchase or sale of a security" element of a § 10(b) claim requires that a misrepresentation "coincide" with or "touch" a securities transaction) (citing S.E.C. v. Zandford, 535 U.S. 813, 822 (2002) and Superintendent of Ins. v. Bankers Life & Casualty Co., 404 U.S. 6, 12 (1971)). For example, the SEC relies upon allegations in paragraph 62 of the Complaint that ITT's 2012 Form 10-K contained certain language. [Filing No. 1 at 17.] Defendants admit that paragraph 62 quotes ITT's 2012 Form 10-K. [Filing No. 33 at 9-10.] But Defendants go on to deny allegations in paragraph 63 that the language in the 2012 Form 10-K was misleading, [see Filing No. 1 at 17-18; Filing No. 33 at 101, and the SEC does not provide undisputed evidence that those statements were misleading.
For the Court to find that the SEC will have proven this element of its § 10(b) claim if it proves that certain allegations (which link public filings to fraudulent conduct) are true would be to issue an impermissible advisory opinion. See Member Services, Inc. v. Sec. Mut. Life Ins. Co. of New York, 2010 WL 3907489, *17 (N.D. N.Y. 2010) (motion requesting summary judgment "based upon the facts that might be proven at trial" seeks an impermissible advisory opinion) (emphasis omitted); Socha v. Pollard, 621 F.3d 667, 670 (7th Cir. 2010) (federal courts may not issue advisory opinions). This issue simply has not been appropriately supported in the SEC's motion, and therefore is not appropriately decided on summary judgment. Obviously, it could be addressed at trial, if appropriate, once the parties have presented their evidence. Depending on the evidence, either party could move for judgment as a matter of law on the purchase or sale element of this claim. See Fed. R. Civ. P. 50(a)(1)(B) ("If a party has been fully heard on an issue during a jury trial and the court finds that a reasonable jury would not have a legally sufficient evidentiary basis to find for the party on that issue, the court may.. .grant a motion for judgment as a matter of law against the party on a claim or defense that, under the controlling law, can be maintained or defeated only with a favorable finding on that issue").
The SEC's efforts to obtain summary judgment on this element of its § 10(b) claim is akin to requesting that the jury be instructed that this element has been conclusively established. But final jury instructions are crafted after the Court has had the benefit of seeing the evidence that the parties have presented to the jury. Without that benefit, it is impossible to know whether, for example, the fraudulent conduct here is linked with the specific public filings the SEC relies upon to satisfy this element of its § 10(b) claim. The SEC's Motion for Summary Judgment as to the purchase or sale element of its § 10(b) claim is DENIED.
The SEC moves for partial summary judgment on all of its claims alleging violations of the anti-fraud provisions of the federal securities laws on the issue of whether Defendants may rely on advice of counsel as a defense to those claims. [See Filing No. 226 at 27-31.] It argues that its anti-fraud claims are based, in part, on allegations that Defendants failed to disclose to ITT's investors information regarding POBOB, misled investors by only disclosing the "net" amount of payments they projected making to the PEAKS Program rather than the more than $100 million in gross cash payments they anticipated, and failed to disclose information about projected cash flows related to the CUSO Program. [Filing No. 226 at 28.] The SEC argues that the evidence shows that Defendants never sought legal advice regarding any of those disclosures. [Filing No. 226 at 29-31.]
In response, Defendants argue that they will present evidence regarding advice of counsel not as an affirmative defense, but as evidence of their lack of scienter or negligence, and that "Defendants are aware of no case in which a court has granted summary judgment to preclude an individual defendant from offering evidence of counsel's advice to show a lack of scienter." [Filing No. 254 at 26-27.] Defendants contend that, in any event, "[t]he record is replete with evidence of in-house and outside counsel's role in repeatedly reviewing, editing, and advising on the specific disclosure issues raised in the SEC's motion." [Filing No. 254 at 27.] Defendants set forth evidence that they argue indicates that they sought legal advice on the three issues the SEC focuses on - POBOB, disclosures relating to the PEAKS Program guarantee payments, and disclosures related to the CUSO Program. [Filing No. 254 at 29-38.]
In its reply, the SEC argues that it is entitled to summary judgment on any affirmative defense based on advice of counsel because Defendants concede that they are not asserting such an affirmative defense. [Filing No. 257 at 19-21.] It also argues that, to the extent the Court considers advice of counsel as it relates to scienter, there are no genuine disputes of fact that Defendants themselves did not seek out or receive such advice. [Filing No. 257 at 21-24.]
The parties' briefs on this issue present a disconnect that the Court must address up front. The SEC's Motion for Summary Judgment only seeks judgment on Defendants' "affirmative defense" that the SEC's fraud-based claims fail because they relied upon advice of counsel. Defendants argue that they do not assert such an affirmative defense, although they state in Affirmative Defense 17 in their Answer that "Defendants are not liable because they relied upon the work, involvement, advice, judgment, and opinions of numerous professionals and subject-matter experts engaged by the company." [Filing No. 33 at 26.] In their Statement of Claims and Defenses, however, Defendants clarify their position by stating that they "are not liable because they relied upon the work, involvement, advice, judgment, and opinions of numerous professionals and subject-matter experts engaged by the company..., including: ITT's in-house attorneys...; [and] outside attorneys.... With respect to reliance on counsel, a defendant's reliance on the advice of counsel demonstrates a lack of scienter (or even negligence), an element necessary to many of the SEC's claims.... Defendants' reliance on counsel is thus not an affirmative defense upon which the Defendants bear the burden of proof." [Filing No. 210 at 4.] Defendants also concede in their response to the SEC's Motion for Summary Judgment that "contrary to the SEC's apparent belief, Defendants are adducing evidence of advice of counsel not as an affirmative defense but as evidence of their lack of scienter or negligence, which are essential elements of the SEC's claims." [Filing No. 254 at 26 (emphasis omitted).] The Court DENIES the SEC's Motion for Summary Judgment since it asks for judgment on an affirmative defense that Defendants have conceded does not exist. That said, the Court also finds that Defendants are bound by their concession and may not rely on advice of counsel as an affirmative defense at trial.[5]
Because the SEC does not move for summary judgment on Defendants' reliance on advice of counsel as a factor to consider in determining scienter, the Court need not address that issue. The Court notes, however, that advice of counsel is a proper consideration in analyzing a defendant's state of mind in connection with securities fraud claims. See, e.g., Securities and Exchange Commission v. Sethi Petroleum, LLC, 2017 WL 3386047, *4 (E.D. Tex. 2017) ("Reliance on counsel is not a formal defense, but rather it is simply a means of demonstrating good faith and represents possible evidence of an absence of any intent to defraud") (citations and quotations omitted); Howard v. S.E.C., 376 F.3d 1136, 1147 (D.C. Cir. 2004) ("reliance on the advice of counsel need not be a formal defense; it is simply evidence of good faith, a relevant consideration in evaluating a defendant's scienter"); United States v. Peterson, 101 F.3d 375, 381 (5th Cir. 1996) (affirming district court's issuance of jury instruction which stated: "To decide whether such reliance [on advice of counsel] was in good faith, you may consider whether the Defendant sought the advice of a competent attorney concerning the material fact allegedly omitted or misrepresented, whether the Defendant gave his attorney all the relevant facts known to him at the time, whether the Defendant received an opinion from his attorney, whether the Defendant believed the opinion was given in good faith and whether the defendant reasonably followed the opinion"). The SEC, however, still has the burden of proof regarding scienter. Securities and Exchange Commission v. Ferrone, 163 F.Supp.3d 549, 568 (N.D. Ill. 2016) ("The SEC has the burden to establish scienter for its claims under Section 10(b) and Rule 10b-5") (citing Aaron v. SEC, 446 U.S. 680, 691 (1980)).
To the extent the SEC believes that certain evidence regarding Defendants' reliance on advice of counsel should be precluded at trial, it may file a motion in limine in advance of trial or object to such evidence at trial. Because the SEC did not move for summary judgment on whether Defendants may rely on advice of counsel as a mitigating factor in determining scienter - which, the Court notes, appears to be based on evidence which is largely disputed - the Court will not address this issue further.
B. Claim One - Scheme Liability Under Exchange Act Rule 10b-5
Rule 10b-5, promulgated by the SEC pursuant to § 10(b) of the Exchange Act, makes it unlawful:
17 C.F.R. § 240.10b-5. "Rule 10b-5 prohibits only conduct that § 10(b) already renders unlawful." In re Akorn, Inc. Securities Litigation, 240 F.Supp.3d 802, 813 (N.D. Ill. 2017).
2. Defendants' Motion for Summary Judgment
Defendants move for summary judgment on the SEC's Rule 10b-5 claim, arguing that certain allegations in the Complaint do not support the SEC's "scheme liability" theory under Rule 10b-5(a) and (c), and that alleged conduct relating to the PEAKS Noteholders, certain disclosures to the shareholders, and conduct relating to the auditor cannot support its Rule 10b-5(b) claim.[6]
a. Scheme Liability Allegations Under Rule 10b-5(a) and (c)
Defendants argue that the SEC relies on alleged acts that "do not independently satisfy the elements of fraud, " and "then aggregates these independent acts and applies a pejorative 'scheme to defraud' label to these acts."[7] [Filing No. 247-1 at 32.] They assert that "scheme liability cannot be predicated upon false or misleading statements absent the existence of inherently deceptive conduct." [Filing No. 247-1 at 32.] Defendants point to the following alleged activities, and argue that they were not inherently fraudulent: (1) the POBOB practice; (2) Mr. Fitzpatrick's alleged failure to consolidate the PEAKS Trust into ITT's financial statements; and (3) misstatements or omissions in SEC filings or earnings calls, to the auditor, or to certain parties, with respect to POBOB. [Filing No. 247-1 at 35-37.] Defendants contend that "the SEC is improperly utilizing scheme liability to pursue a case that is really about the propriety of ITT's public disclosures, when it has no evidence of deceptive conduct beyond alleged misstatements and omissions. This is an impermissible expansion of scheme liability...." [Filing No. 247-1 at 37.]
In response, the SEC argues that it need not show deceptive conduct beyond misstatements, and that this issue has not been addressed by the Seventh Circuit Court of Appeals. [Filing No. 251 at 27.] It contends that, if required, there is substantial evidence of conduct beyond misstatements to support its Rule 10b-5 scheme liability claim, including Defendants lying to auditors and the PEAKS Noteholders about the POBOB practice, and Defendants engaging in deceptive conduct to avoid consolidating the PEAKS Trust into ITT's financial statements. [Filing No. 251 at 28-30.]
In reply, Defendants argue that "the SEC asks this Court to read a prohibition against deceptive statements into Rule[ ] 10b-5(a) and (c), " but that doing so "would render Rule 10b-5(b).. .superfluous." [Filing No. 258 at 12.] Defendants reiterate their argument that the majority of courts have held that Rule 10b-5 requires deceptive conduct beyond false or misleading statements. [Filing No. 258 at 14-15.] They also assert that even if deceptive statements could create scheme liability, the nondisclosure of POBOB to the PEAKS noteholders would not support scheme liability because Rule 10b-5 liability cannot extend beyond § 10(b) liability, § 10(b) prohibits only conduct that is manipulative or deceptive, and a nondisclosure of information cannot be deceptive absent a duty to disclose it. [Filing No. 258 at 16-17.]
The Seventh Circuit Court of Appeals has not considered the issue of whether Rule 10b-5(a) and (c) require deceptive conduct beyond mere misstatements or omissions, but the majority of courts that have considered the issue have required deceptive conduct that is distinct from the alleged misrepresentations and omissions. See, e.g., Rabkin v. Lion Biotechnologies, Inc., 2018 WL 905862, * 16-17 (N.D. Cal. 2018) ('"A defendant may only be liable as part of a fraudulent scheme based upon misrepresentations and omissions under Rules 1 Ob-5(a) or (c) when the scheme also encompasses conduct beyond those misrepresentations or omissions'") (quoting WPP Luxembourg Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039, 1057 (9th Cir. 2011)); United States Securities and Exchange Commission v. Wey, 246 F.Supp.3d 894, 918 (S.D. N.Y. 2017) (finding that plan to move shares into brokerage accounts was "deceptive even without the later misrepresentation, " and supported Rule 10b-5(a) and (c) claims); S.E.C. v. Cole, 2015 WL 5737275, *8 (S.D. N.Y. 2015) (noting that courts "have repeatedly allowed both 'scheme liability' and deceptive statement claims to go forward 'where the plaintiffs allege both that the defendants made misrepresentations in violations of Rule 10b-5(b), as well as that the defendants undertook a deceptive scheme or course of conduct that went beyond the misrepresentations'") (emphasis omitted) (quoting In re Alstom SA, 406 F.Supp.2d 433, 475 (S.D.N.Y. 2005)); In re CytRx Corporation Securities Litigation, 2015 WL 5031232, *12 (CD. Cal. 2015) (SEC properly alleged scheme liability where allegations "also included conduct beyond [misstatements], including the hiring of promoters, planning and editing well-timed article releases with targeted content to artificially inflate the value of company stock and raise revenue, and covering up the Company's involvement").
The Court follows the majority of other courts and finds that the SEC must show more than misstatements or omissions in order to succeed on its Rule 1 Ob-5(a) and (c) scheme liability claims. This approach comports with the plain language of Rule 10b-5. Part (b) prohibits the making of any untrue statement of material fact or omission of material fact necessary in order to make the statement made, in light of the circumstances under which they were made, not misleading. In other words, part (b) prohibits misstatements and omissions. It would render part (b) superfluous if the Court were to read parts (a) and (c) as not requiring anything more than misstatements or omissions. Rather, the Court finds that scheme liability requires something more - deceptive acts along with misstatements or omissions.
Because the Court finds that the SEC must show that Defendants engaged in deceptive acts in addition to misstatements and omissions, it need not consider whether the misstatements discussed by the parties - failure to disclose the POBOB practice to the PEAKS Noteholders, failure to disclose ITT's internal projections of its PEAKS cash obligations, failure to disclose certain information in the Management Discussion and Analysis ("MD&A") section of ITT"s public filings, failure to disclose the POBOB practice in the Form 10-Q for the third quarter of 2012, and failure to disclose ITT's CUSO guarantee liability - are enough to support the Rule 10b- 5 claim. The Court also need not consider the SEC's argument that these misstatements or omissions caused other statements to be false and misleading. [See, e.g., Filing No. 251 at 33-34.] Rather, the Court finds that the SEC has presented enough evidence of deceptive acts, which are separate and apart from misstatements and omissions in ITT's public filings and analyst calls, that Defendants are not entitled to summary judgment on the SEC's Rule 10b-5 claim. This evidence includes deceptive acts related to the information Defendants provided to auditors, including:
• not informing auditors regarding POBOB and that the PEAKS Noteholders had objected to POBOB, [see, e.g., Filing No. 250-4 at 12-13; Filing No. 250-4 at 29-30; Filing No. 250-11 at 3-4; Filing No. 250-12 at 41;
&bull; not informing auditors regarding outside counsel telling Defendants that POBOB likely was prohibited, [Filing No. 250-4 at 32; Fi ...