GFL Advantage Fund v. Colkitt

Opinions of the United

2001 Decisions States Court of Appeals

for the Third Circuit

11-16-2001

GFL Advantage Fund v. Colkitt

Precedential or Non-Precedential:

Docket 00-2428

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Filed 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 Appellee

Peter 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 Advantage

Fund, Ltd. against Colkitt entered on April 25, 2000, and

on appeal from an order entered on July 17, 2000, denying

reconsideration of the April 25 order. For the reasons stated

herein, we will affirm the orders of the district court.

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 -- EquiMed, Inc.

("EquiMed") and National Medical Financial Services

Corporation ("National Medical"). As of February 1996,

Colkitt held 20,783,633 (73%) of EquiMed's 28,589,717

outstanding shares of common stock, and as of May 1996,

he owned 2.8 million (38%) of National Medical's 7,426,844

outstanding shares of common stock. See GFL Advantage

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 pursue

various business ventures unrelated to EquiMed and

2

National Medical. After unsuccessfully attempting to secure

financing from traditional commercial lending institutions,

Colkitt contacted alternative lenders that might be willing

to structure "convertible or exchange transactions,"

whereby Colkitt would be able immediately to convert his

vast stockholdings into cash. In particular, Colkitt

endeavored to borrow money by pledging his common stock

as collateral and providing the lender with the right 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 principal for

shares of National Medical stock held by Colkitt at an

exchange rate of 82% of the average market price. GFL

could exchange the remainder of the unpaid balance for

shares of National Medical 60 days after the date of the

note. The average market price was computed by taking the

average of the stock's closing prices for the five days

immediately prior to the exchange request. In essence, 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 with a

premium value to repay a debt of a lesser amount.

Several months later on August 5, 1996, Colkitt entered

into a similar transaction with GFL for a $10,000,000 loan.

The structure of the second note ("EquiMed note") was akin

to that of the National Medical note, except the parties

agreed that GFL could convert the debt into shares of

Colkitt's other business, EquiMed, Inc., at an exchange rate

of 83% of the average market price. In addition, GFL could

convert up to $5 million of the outstanding principal after

60 days of the date of the note and could convert the

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

3

exchanged $250,000 of debt for 34,130 shares of National

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 price of

$5.46. On December 5, 1996, GFL exchanged $100,000 of

unpaid principal for 14,845 shares at an average market

price of $8.725 and an exchange price of $6.74. On

December 19, 1996, GFL converted $200,000 of debt into

34,588 shares at an average market price of $7.525 and a

conversion price of $5.78. Finally, on January 7, 1997, 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 for

EquiMed stock.

GFL waited until November 1996, more than 3 months

after the date of the EquiMed note, before making its 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 five-day

average closing price of $4.50, GFL received 150,555 shares

of EquiMed at an exchange rate price of $3.72. GFL's next

exchange demand for EquiMed stock occurred on January

3, 1997, when GFL sought to convert $1,430,000 in unpaid

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 National

Medical stock. As we have explained:

Short selling is accomplished by selling stock 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 shares 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; the short

4

seller then pockets the difference. On the other hand,

there is no limit to the short seller's potential loss: if

the price of the stock rises, so too does the short

seller's loss, and since there is no cap to a stock's

price, there is no limitation on the short seller'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 short sale as

"any sale of a security which the seller does not own or any

sale which is consummated by the delivery of a security

borrowed by, or for the account of, the seller"); Black'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 seller must

borrow to make delivery"). In other words, short sellers are

betting that the stock price will decline between the 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 regulated,

see, e.g., 17 C.F.R. S 240.10a-1, is a legitimate trading

strategy for stocks that traders believe are overvalued.

GFL's first short sale of National Medical stock occurred

on September 13, 1996, when it sold 32,500 shares at a

price of $10.00 per share. On September 16, 1996, GFL

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 Medical

at $8.25 per share. GFL sold short a total of 62,500 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 EquiMed

-- 10,000 shares at $5.50 per share and 8,400 shares at

$5.48 per share. On November 11, 1996, GFL sold short

32,500 shares at $5.38 per share. On November 12, 1996,

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. Over

this two-week period in November 1996, GFL sold short a

total of 78,700 shares of EquiMed stock.

5

GFL explains that it engaged in short sales of National

Medical and EquiMed stock as a hedging strategy against

"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 the 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 dropped

more than the agreed-upon discount before GFL was able

to sell the exchanged shares, GFL would be in a loss

position." Br. of Appellee at 7. GFL claims it sold short to

protect itself in the event that the price of the stock

declined further after GFL made the exchange request 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 effort to

depress the prices of the stocks. Indeed, Colkitt contends

that the market price of National Medical dropped 17.5%

between GFL's first and last short sales of National Medical

stock, and that the market price of EquiMed declined by

18.5% between GFL's first short sale of EquiMed stock and

GFL's first exchange demand.1 Colkitt argues that GFL

purposely depressed the stock prices so that Colkitt would

be forced to exchange more shares to retire the same

amount of debt. He asserts that GFL was able to obtain an

additional 27,882 shares of EquiMed and an additional

11,658 shares of National Medical due to the respective

declines in the stocks' prices.

_________________________________________________________________

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, 1996, 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, however, if the price

decline of EquiMed stock is measured during the period between GFL's

first and last short sales, EquiMed's price drop would be approximately

2%. See Br. of Appellee at 36. More specifically, the 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 represents only a 2.3%

decrease.

6

As noted above, Colkitt refused to honor GFL's exchange

request for EquiMed shares on January 3, 1997. Instead,

Colkitt notified GFL in December 1996 and early January

1997 that he intended to prepay all unpaid principal and

interest in cash. Colkitt contends that GFL improperly

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 dictate the

terms of any prepayment and disagreed with Colkitt about

the amounts due. GFL admits that it does not believe that

Colkitt had a right to prepay, but insists that it"accepted

Colkitt's offer to prepay whatever amount Colkitt believed

was then due, reserving for itself the right to contest the

disputed balance." Br. of Appellee at 13. GFL claims that

Colkitt neither responded to its overtures nor attempted to

prepay or pay any amounts to GFL.

B. PROCEDURAL HISTORY

On April 4, 1997, GFL filed a complaint against Colkitt

alleging breach of his obligations on the National Medical

and EquiMed notes. On June 6, 1997, Colkitt filed an

answer, affirmative defenses, and six counterclaims. The

affirmative defenses and counterclaims alleged, inter alia,

that GFL engaged in securities fraud and market

manipulation in violation of various federal and state

securities laws by temporarily depressing the prices 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 shares at

an artificially low price and earn enormous windfall profits

when prices returned to their normal levels. On March 31,

1998, the district court adopted a magistrate judge's

recommendations that Colkitt's counterclaims be

dismissed. The district court dismissed one counterclaim

with prejudice and the balance without prejudice. 2 On April

_________________________________________________________________

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 (Pennsylvania 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)

7

20, 1998, Colkitt filed amended counterclaims in an effort

to cure the deficiencies of the original counterclaims, but

on February 2, 1999, the district court again dismissed

Colkitt's inadequately pled counterclaims without prejudice

for lack of specificity.

On April 25, 2000, the district court granted summary

judgment in favor of GFL based largely on the reasoning of

In re Olympia Brewing Co. Securities Litigation , 613 F.

Supp. 1286 (N.D. Ill. 1985). The court concluded that,

because short selling is not an unlawful trading practice, it

would not draw the inference that GFL manipulated the

market price of EquiMed and National Medical stocks

simply because GFL engaged in substantial short selling of

the stocks. The court also determined that Colkitt failed to

present evidence that GFL's short sales had an appreciable

effect on the prices of the stocks. Finally, the court

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 available

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 judgment in

favor of GFL. The court clarified its earlier ruling on GFL's

motion for summary judgment, explaining that the evidence

of GFL's short sales alone was insufficient to establish

Colkitt's claims of securities fraud and market

manipulation because selling stocks short is lawful. The

court declared that "[t]here must be some circumstances

beyond the mere occurrence of short sales to suggest that

_________________________________________________________________

with prejudice, subject to reinstatement in the event that we recognize a

private right of action under Section 17 of the Securities Act of 1933, 15

U.S.C. S 77q(a). The court dismissed counterclaim count 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 with prejudice, the court

concluded on reconsideration that the order was in error and changed

the dismissal to a dismissal without prejudice.

8

the short sales were part of a scheme to manipulate the

market," which Colkitt failed to proffer. GFL Advantage

Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and

Order at 14 (M.D. Pa. July 17, 2000). The court then

proceeded to reject Colkitt's argument that numerous

inferences that he believed should be drawn from the

factual record created genuine issues of material fact that

precluded summary judgment. The court refused to accept

any of Colkitt's proffered inferences -- each of which 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 judgment in

this case on July 17, 2000, and appellant filed a timely

notice of appeal on August 15, 2000. Therefore, we have

jurisdiction pursuant to 28 U.S.C. S 1291. 3

_________________________________________________________________

3. As noted above, the district court twice dismissed certain of Colkitt's

counterclaims without prejudice for lack of specificity. In some

circumstances, such a dismissal could deprive us of appellate

jurisdiction as "ordinarily we do not have jurisdiction under 28 U.S.C.

S 1291 of an appeal from an order partially adjudicating a case when an

appellant has asserted a claim in district court which it has withdrawn

or dismissed without prejudice." Erie County Retirees Ass'n v. County of

Erie, 220 F.3d 193, 201 (3d Cir. 2000). Our case law, however, allows us

to exercise appellate jurisdiction under 28 U.S.C.S 1291 when the

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

Here,

although the district court's orders dismissed Colkitt's counterclaims

without prejudice, the court's summary judgment order effectively barred

Colkitt from re-filing them, for the court concluded 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 suit 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 prejudice 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.

9

B. STANDARD OF REVIEW

We review the district court's grant of summary judgment

de novo and apply the same standard as the district court

applied in the first instance. See Lucent Info. Mgmt., 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 in the

light most favorable to Colkitt, "there is no genuine issue as

to any material fact" and GFL is "entitled to a judgment as

a matter of law." Fed. R. Civ. P. 56(c). As the nonmoving

party, Colkitt must create a genuine issue of material fact

by presenting sufficient evidence to permit a jury to find in

his favor. See Anderson v. Liberty Lobby, Inc. , 477 U.S. 242,

248, 106 S. Ct. 2505, 2510 (1986). To defeat summary

judgment, he "cannot rest simply on the allegations in the

pleadings," but "must rely on affidavits, depositions,

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 insufficient

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 EquiMed

notes are unenforceable by reason of Section 29 of the

Securities Exchange Act of 1934 ("Exchange Act") because

GFL violated the anti-fraud provisions under Section 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 provision of this

chapter or of any rule or regulation thereunder, . .. [or]

the performance of which involves the violation of, or

the continuance of any relationship or practice 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 argues that

GFL violated Section 10(b) and Rule 10b-5 when it engaged

10

in market manipulation by short selling National Medical

and EquiMed stock in an effort to depress the share prices,

and when it engaged in fraudulent deception by concealing

its plan to short sell National Medical and EquiMed stock.

See Br. of Appellant at 24. Colkitt asserts that the 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 and

EquiMed stock and (2) they contain omissions of material

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 another

section of the Exchange Act has been violated. As

addressed below, GFL maintains that it did not engage in

either market manipulation or securities fraud in violation

of Section 10(b), and therefore, there is no underlying

offense to trigger Section 29(b). See infra pp. 17-36. Second,

GFL contends that Colkitt fails to state a proper Section

29(b) defense inasmuch as Colkitt alleges that it is GFL's

short selling, not the National Medical and EquiMed notes,

that is unlawful. GFL argues that only "unlawful contracts,"

not "unlawful transactions" executed pursuant to lawful

contracts, may be rescinded under Section 29(b).

We deal with GFL's second contention first, which is

supported by the limited body of case law on the point. 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 Stearns. He

purchased millions of dollars of government bonds in 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 account and

failed to muster the $155,000 in additional margin

demanded, Bear Stearns liquidated the government bonds

in plaintiff's account. See id. Plaintiff alleged that Bear

Stearns violated Section 10(b) and Rule 10b-16 by failing to

provide him at the time he opened his accounts with a

written statement explaining the terms under which Bear

11

Stearns would extend him credit. See id. Based on these

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 the

transactions, explaining:

The complaint alleges that Bear Stearns failed to send

plaintiff a written credit disclosure statement in

violation of Rule 10b-16 at the time he opened his

accounts; it does not allege that the customer

agreements establishing his margin and repurchase

accounts at Bear Stearns were themselves unlawful

. . . . `[U]nder S 29 of the Exchange Act, only unlawful

contracts may be rescinded, not unlawful transactions

made pursuant to lawful contracts.'

Id. at 681-82 (quoting Zerman v. Jacobs , 510 F. Supp. 132,

135 (S.D.N.Y. 1981), aff'd, 672 F.2d 901 (2d Cir. 1981)

(table)). Because Bear Stearns's alleged violation of Rule

10b-16 was "clearly collateral to the contract agreement

governing the account," the court determined that the

firm's failure to provide the written statement to plaintiff

did "not justify rescission of the account agreement itself or

the transactions undertaken pursuant to that agreement."

Id. at 682-83.

In Drasner v. Thomson McKinnon Securities, Inc. , 433 F.

Supp. 485, 488-89 (S.D.N.Y. 1977), plaintiffs maintained

margin accounts with defendant Thomson McKinnon

Securities between 1973 and 1975. Plaintiffs began selling

naked options in 1974 and profited handsomely off the

transactions until 1975, when the market began spiking

upward. See id. Between January and May 1975, plaintiffs

incurred substantial losses on their options until Thomson

McKinnon finally closed their accounts and liquidated their

collateral. See id. at 489. Plaintiffs sought to rescind the

options contracts pursuant to Section 29(b) because

Thomson McKinnon allegedly violated Regulation T by

failing to direct plaintiffs to deposit the required 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 the Act or

the rules and regulations thereunder . . . for it is only such

contracts which are `made in violation of,' or`the

12

performance of which involves the violation of' the statute

and the rules and regulations thereunder." Id. at 501-02.

The court explained that even if Thomson McKinnon had

violated Regulation T, Section 29(b) was inapplicable

because the options contracts that plaintiffs sought to

rescind were governed by a valid, lawful contract whose

terms did not violate the Exchange Act or any regulations

promulgated thereunder. See id. at 502.

Colkitt responds to GFL's argument by citing Regional

Properties, Inc. v. Financial and Real Estate Consulting 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 suit

against their broker and his firm, Financial and Real Estate

Consulting Co. ("Financial"), alleging that the broker had

violated Section 15(a)(1) of the Exchange Act by selling

limited partnership interests for them without having

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 of Section

15(a)(1). See id. The court rejected Drasner's conclusion

that Section 29(b) renders void only those contracts that

"by their terms" violate the Exchange Act and instead

interpreted Section 29(b) as "render[ing] voidable those

contracts that are either illegal when made or as in fact

performed." Id. at 560. The court concluded that rescission

was proper because, although plaintiffs sought to avoid

contracts that were "perfectly lawful on their face," the

performance of the contracts by Financial nevertheless

"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 Properties

rescinded the contracts therein and explicitly rejected

Drasner's narrow reading of Section 29(b), its opinion is

nevertheless consistent with the outcomes in Drasner,

Slomiak, and Zerman. In particular, the violations of the

Exchange Act alleged in Drasner, Slomiak , and Zerman were

"collateral or tangential to the contract between the

13

parties," whereas the violation alleged in Regional Properties

was "inseparable from the performance of the contract" that

plaintiffs were attempting to void. Slomiak, 597 F. Supp. at

682. The parties could -- and did -- perform the contracts

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 his

obligations under the agreements without violating the

Exchange Act, for performance of the agreements entailed

selling partnership interests, which the broker lawfully

could not do due to his failure to register as a broker-

dealer.

The other two cases cited by Colkitt are also consistent

with this analysis. In both cases, the courts voided loan

agreements because the banks violated Regulation U, which

governs the amount of money that a bank can lend for the

purchase of registered securities. In Grove v. First National

Bank of Herminie, 489 F.2d 512, 513 (3d Cir. 1974) (per

curiam), bank employees failed to explain to plaintiff that

under federal law, the bank "could lend only a certain

percentage of the market value of stock to purchase

registered securities." Concluding that the bank had

violated Regulation U, we held that Section 29(b) precluded

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. 24, 28

(S.D.N.Y. 1975), a bank sought to recover the outstanding

balance on a loan, but the borrower claimed that the 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 court

disagreed, holding that "if the principal obligation violates

Regulation U, a guarantee of that obligation is void under

S 29(b) of the Exchange Act." Id. The court explained that

"allow[ing] a bank to recover on a guarantee even though

the underlying loan violated Regulation U would encourage

banks to extend credit in violation of the margin

requirements." Id. at 34.

14

As with the violation of Section 15(a)(1) in Regional

Properties, the violations of Regulation U in Grove and

Stonehill were inseparable from the underlying agreements

between the parties: the banks could not perform their

obligations under the loan agreements (i.e., lend money to

the borrowers so that they could purchase securities)

without violating Regulation U. In fact, the loans were

"made in violation of" the Exchange Act because a greater

percentage of the loans was used to purchase securities

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. GFL's

allegedly unlawful short sales of National Medical and

EquiMed stock were nothing more than "collateral or

tangential" to the notes. Colkitt insists that performance 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 which 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 obligations

under the terms of the notes -- namely, GFL's obligation to

lend Colkitt a total of $13,000,000, and Colkitt's obligation

to repay the loans at GFL's option with shares of National

Medical and EquiMed stock. In the end, GFL's alleged

unlawful activity (i.e., its short sales) is too attenuated from

the parties' valid, lawful contracts (i.e., the National 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 securities laws as

is required for rescission under Section 29(b). 4

B. MARKET MANIPULATION

Colkitt argues that the district court erred in rejecting his

affirmative defense that the notes are void pursuant to

Section 29(b) due to GFL's alleged market manipulation, as

_________________________________________________________________

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.

15

there exist genuine issues of material fact regarding

whether GFL's short sales constituted market manipulation

in violation of Section 10(b) and Rule 10b-5. GFL argues,

however, that Colkitt has not presented enough evidence to

create triable issues on any of the elements of market

manipulation.5

_________________________________________________________________

5. GFL also insists that Colkitt cannot obtain reversal of summary

judgment with respect to GFL's alleged manipulation of National

Medical's price because Colkitt abandoned his market manipulation and

securities fraud claims with respect to National Medical by conceding

that GFL's short sales of National Medical stock did not violate any

securities laws. See Br. of Appellee at 19-21. To support its contention,

GFL quotes a passage from Colkitt's opposition to GFL's motion for

summary judgment, which states that "[t]he short selling of National

Medical presents an interesting contrast to the short selling of EquiMed."

Id. at 20 (quoting Colkitt's Brief in Opposition to Summary Judgment at

6 (App. 000837)). GFL claims that this statement, along with other

unspecified passages in Colkitt's opposition and his motion for

reconsideration, led the district court to limit its rulings to only the

EquiMed note.

GFL's argument is without merit. A review of the district court's April

25, 2000 Memorandum reveals that the court addressed Colkitt's market

manipulation and securities fraud claims as to both EquiMed and

National Medical. Indeed, National Medical is mentioned throughout the

district court's summary judgment and reconsideration rulings. There is

no indication in the district court's rulings that Colkitt abandoned these

claims or that the court limited its rulings to only the EquiMed note.

GFL also distorts the meaning of the above-quoted passage by taking

it out of context. When Colkitt admitted that the short sales of National

Medical differed in some respects to the short sales 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 detail below, see infra

pp. 28-30, Colkitt's expert maintains that selling short prior to the

five-

day period before the exchange demand is not a legitimate hedging

strategy, but instead an attempt to profit from declining stock prices.

The expert insists that if GFL were only trying to hedge against a

possible drop in price after the exchange demand (so-called "delivery

risk"), GFL could have eliminated that risk by selling short during the

five-day period before the exchange demand -- in essence, locking in the

sale price during the same period the average closing price would be

calculated. Colkitt's statement was simply an "acknowledgment that,

unlike the EquiMed shorts, the National Medical shorts, by their timing,

could at least qualify as a hedge strategy" because they were made

16

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

and Rule 10b-5

As an initial matter, the parties disagree about the specific

elements of market manipulation under Section 10(b) and

Rule 10b-5. To complicate matters further, we seemed not

to have addressed squarely what elements are required to

establish a claim of market manipulation, particularly 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 purchase or

sale of any security . . ., any manipulative or deceptive

device or contrivance in contravention of such rules 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 define a

"manipulative or deceptive device or contrivance," Colkitt

turns to Section 9(a) of the Exchange Act to determine the

elements of the offense of market manipulation. Section

9(a) prohibits individuals from effecting "a series of

transactions in any security registered on a national

securities exchange . . . creating actual or apparent active

trading in such security, or raising or depressing the price

of such security, for the purpose of inducing the purchase

or sale of such security by others." 15 U.S.C.S 78i(a)(2).

Based on this passage and the Supreme Court's decision in

Aaron v. SEC, 446 U.S. 680, 695, 100 S.Ct. 1945, 1955

(1980), in which the Court recognized scienter as an

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 following

_________________________________________________________________

within the days immediately preceding GFL's exchange 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.

17

elements 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 to sell

the securities; (3) GFL's short sales created "actual or

apparent active trading" in the securities or depressed the

prices of the securities; and (4) GFL acted with scienter.

GFL responds that Colkitt has mischaracterized the

elements of market manipulation by applying an overly

broad description of prohibited activities set forth under

Section 9(a) and by ignoring the specific requirements of

market manipulation that have evolved over time. GFL

points out that market manipulation is "virtually a term of

art when used in connection with the securities market. It

connotes intentional and willful conduct designed to

deceive or defraud investors by controlling or artificially

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 elements

of a market manipulation claim -- that "GFL injected

inaccurate information into the marketplace" and that

GFL's conduct "affected the price" of National Medical and

EquiMed stock. Br. of Appellee at 24.

The first disputed element is whether Colkitt must

demonstrate that GFL injected inaccurate information into

the marketplace or created a false impression of market

activity. Like the district court, GFL relies on Olympia

Brewing, 613 F. Supp. at 1292, in which the district court

emphasized that the "essential element" of a market

manipulation claim is the injection of "inaccurate

information" into the market. GFL observes that even the

cases cited by Colkitt "recognize that market manipulation

requires an additional element, something beyond

otherwise legal trading, which specifically injects false

information into the market and/or creates an artificial

demand for the underlying security." Br. of Appellee at 22

(emphasis added). Colkitt responds, however, that he is not

required to present evidence that "GFL injected affirmative

misinformation into the market," but only needs to

demonstrate that "GFL's short trades were made for the

undisclosed purpose of artificially depressing share prices."

Reply Br. of Appellant at 9 (emphasis added).

18

Notwithstanding Colkitt's assertion to the contrary, the

parties appear to be in accord on this point. Indeed, 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 artificially

depress or inflate prices, whether by purposely making

false statements or by employing illegitimate, deceptive

trading techniques that mislead investors about the price or

demand for a stock.

To the extent that the parties' respective positions 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 indicated that

market manipulation "generally refers to practices, such as

wash sales, matched orders, or rigged prices, that are

intended to mislead investors by artificially affecting market

activity." Santa Fe Indus. v. Green, 430 U.S. 462, 476, 97

S.Ct. 1292, 1302 (1977). "The gravamen of manipulation is

deception of investors into believing that prices at 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 between

legitimate trading strategies intended to anticipate and

respond to prevailing market forces and those designed to

manipulate prices and deceive purchasers and sellers.

Although Colkitt's construction properly reflects the

aspiration of Section 10(b) of preventing market activities

that artificially depress prices, it provides little guidance on

which activities artificially affect prices and which activities

legitimately impact prices.

Requiring a Section 10(b) plaintiff to establish that the

alleged manipulator injected "inaccurate information" into

the market or created a false impression of market activity

cures this problem. Such a construction permits courts to

differentiate between legitimate trading activities that

permissibly may influence prices, such as short sales, and

"ingenious devices that might be used to manipulate

securities prices," Santa Fe Indus., 462 U.S. at 477, 97 S.

Ct. at 1303, such as wash sales and matched orders. As

the court in Olympia Brewing, 613 F. Supp. at 1292,

19

stated, "[r]egardless of whether market manipulation is

achieved through deceptive trading activities or deceptive

statements as to the issuing corporation's value, it is clear

that the essential element of the claim is that inaccurate

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 and

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 price. 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 some

change in price, because of the prohibited acts," the case

involved an alleged violation of Section 9, not Section 10(b)

and Rule 10b-5. Second, the opinion in United States v.

Russo, 74 F.3d 1383, 1394 (2d Cir. 1996), is not significant

here because it only addressed the propriety of the portion

of the district court's jury instruction on the scienter

element that defined artificial price as the price level above

the stock's actual value as determined by market forces.

Third, the decision in In re Blech Securities Litigation, 928

F. Supp. 1279, 1298 (S.D.N.Y. 1996) (citation omitted),

directly contradicts GFL's position by stating that"[t]he

absence of allegations of market dominance and price

movement are not fatal to" a claim of market manipulation,

for although "these may be classic attributes of market

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 other

hand, when confronted with evidence that the prices of the

stocks were on a sharp downward trend before and after

GFL's short sales, thus raising serious doubts about the

true reason for the declining prices, Colkitt reverses course

and argues that he need not prove that GFL's alleged

scheme was successful in depressing prices. Colkitt insists

that he only must establish that GFL attempted to depress

20

prices 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 appears to

be correct that he need not prove that GFL's manipulative

conduct actually depressed prices. The Court of Appeals for

the Fifth Circuit concluded in Chemetron Corp. v. Business

Funds, Inc., 718 F.2d 725, 728 (5th Cir. 1983), that Section

10(b), unlike Section 9(a), does not require that a plaintiff

prove the allegedly unlawful activities had an effect on the

price of the stock. Although any damages that Colkitt

would be entitled to recover under his Section 10(b) and

Rule 10b-5 counterclaim would be contingent on proving

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 necessary

to support his assertion of an affirmative defense under

Section 29(b).6

_________________________________________________________________

6. Although maintaining a private right of action under Section 10(b)

requires a plaintiff to prove reliance and damages (usually reflected in

the stock's price movement), Section 29(b) only requires a violation of

Section 10(b), not the maintenance of a private suit 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 manipulative 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 remedy, inasmuch as

the government need not demonstrate that the defendant'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 stock 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 establish a claim of

market manipulation, the district court still erred in concluding that

Colkitt failed to create a genuine issue of material fact with respect to

price movement. As already noted, Colkitt claims that the price of

21

We are satisfied that, at bottom, neither party properly

articulates the elements of market manipulation under

Section 10(b) in the context of a Section 29(b) affirmative

defense. Because we have not squarely addressed this

issue, we must set forth the necessary elements for such a

claim. In this regard, we conclude that to establish a

Section 29(b) affirmative defense of market manipulation in

violation of Section 10(b) and Rule 10b-5, Colkitt must

present evidence that (1) in connection with the purchase

or sale of securities, (2) GFL engaged in deceptive or

manipulative conduct by injecting inaccurate information

into the marketplace or creating a false impression of

supply and demand for the security (3) for the purpose of

artificially depressing or inflating the price of the security.

2. Evidence Supporting Colkitt's Claim of Market

Manipulation

Colkitt's affirmative defense based upon GFL's alleged

market manipulation fails because he cannot demonstrate

_________________________________________________________________

National Medical dropped 17.5% and the price of EquiMed plummeted

18.5% during the period of GFL's short sales. The district 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 observed 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 preceding 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 on 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, the district court

concluded that Colkitt could not prove that GFL's short sales had an

effect on the price of either National Medical or EquiMed stock. Although

the court was correct that other factors clearly were contributing to the

slide in prices, it was not within the court's province to weigh the

evidence as a finder of fact. Whether and how much GFL's alleged

unlawful conduct contributed to the downturn in prices 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.

22

that GFL engaged in any deceptive or manipulative conduct

by injecting false inaccurate information into the

marketplace or creating a false impression of supply and

demand for the stock. As the district court explained

repeatedly in its two rulings, Colkitt has not presented any

evidence that GFL did anything but lawfully engage in short

sales of National Medical and EquiMed stock. The fact that

these short sales may have contributed to a decline in the

stocks' prices is not evidence of deceptive or manipulative

conduct, for there is no reason to believe these prices 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" did not

create "a false impression of supply and demand" because

on the other side of defendant's transactions were"real

buyers, betting against [defendant], however foolishly, that

the price of [the] stock would rise"); Olympia Brewing, 613

F. Supp. at 1296 (stating that "short selling is simply not

unlawful, even in large numbers and even if the trading

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 concluded that

a party's short selling was part of a scheme to manipulate

stock prices, the short selling was in conjunction with some

other deceptive practice that either injected inaccurate

information into the market or otherwise artificially 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 artificially inflate

stock prices); United States v. Regan, 937 F.2d 823, 829 (2d

Cir. 1991) (defendants sought to depress temporarily the

price of stock by arranging to have 40,000 shares sold

short secretly to a broker-dealer without disclosing to the

dealer the identity of the seller or the moving party behind

the deal); United States v. Charnay, 537 F.2d 341, 344 (9th

Cir. 1976) (to facilitate a take-over bid, defendants

23

artificially depressed stock prices by getting others 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, 1996)

(defendant attempted to depress stock prices through short

sales that contravened Section 10(a) of the Exchange Act

and Rule 10a-1 thereunder, which prohibits a short sale

"below the price at which the last sale" of the security 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 information

into the market or creation of a false impression of supply

and demand for a stock. See Santa Fe Indus., 430 U.S. at

467, 97 S.Ct. at 1298 (defendant obtained "fraudulent

appraisal" of stock that severely undervalued its worth "in

order to lull the minority stockholders into erroneously

believing that [its cash-exchange offer] was generous");

Crane Co. v. Westinghouse Air Brake Co., 419 F.2d 787,

792-93 (2d Cir. 1969) (in an effort to inflate prices and

thwart a corporate take-over, defendant "painted the tape"

by purchasing large blocks of stock in the open market at

inflated prices while simultaneously making large secret

and unreported sales at lower prices to partially finance the

purchases); Blech, 928 F. Supp. at 1286, 1298 (defendant

arranged "sham transactions" to inflate prices by

improperly directing trades into and out of brokerage

accounts at the firm without the authorization of the

owners of the accounts); SEC v. Kimmes, 799 F. Supp. 852,

856-57 (N.D. Ill. 1992) (defendant maintained artificially

high stock prices by buying and selling stock through

"undisclosed nominee accounts," distributing"false and

misleading registration statements," and filing"false 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. 1992)

(defendant arranged "matched buy and sell orders" to

"create a misleading appearance of active trading in the

Texscan common stock" and thus drive up the price of the

24

stock). Once again, Colkitt fails to proffer any evidence that

GFL engaged in any such inappropriate conduct.

Colkitt attempts to overcome this dearth of evidence of

deceptive or manipulative conduct on the part of GFL by

claiming that short sales, by their very nature,"convey to

market participants negative information about the

prospects of the firm." Br. of Appellant at 39. Colkitt's

argument misses the mark, however, because conveying

negative information about a firm does not constitute

market manipulation unless the information is untruthful.

Indeed, legitimate short sales often convey negative

information about a company insofar as short sales suggest

that a stock's price is overvalued, but that does not 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 efficient

marketplace in which stock prices reflect all available

relevant information about the stock's economic value. See

Sullivan & Long, 47 F.3d at 861-62.

Colkitt maintains that National Medical and EquiMed

were not overvalued. He insists that, because GFL did not

argue before the district court that it sold short because it

believed the stocks were overvalued, Colkitt is entitled to

the inference that "the short sales were made at least in

part to convey to the market the false impression that the

stocks were overvalued so as to result in a decline in share

prices." Br. of Appellant at 40 (emphasis in original). It

would not be reasonable to draw such an inference,

however, for to do so would fly in the face of uncontradicted

evidence that the prices of National Medical and EquiMed

were on a dramatic slide before and after GFL's short sales.

If we were to draw any inference from the record evidence

about the value of National Medical and EquiMed, it would

be that the market considered the stocks to be overvalued

and that GFL simply was responding to market forces,

rather than distorting them, by engaging in short sales.

An examination of Colkitt's other requested inferences,7

_________________________________________________________________

7. The parties disagree about the standard of review that should be

applied to Colkitt's requested inferences. GFL contends that the standard

25

see Br. of Appellant at 30-35, exposes Colkitt's claims for

what they are -- nothing more than a general attack on the

lawful practice of short selling. For instance, Colkitt's first

two inferences -- that GFL had a "unique financial

incentive" to depress the prices of National Medical and

EquiMed because its profits increased as the market prices

decreased,8 and that short selling "conveys negative

information" about the company being short sold and

contributes to a drop in share prices -- are general

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 GFL's short

_________________________________________________________________

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 the 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 allows GFL to receive more

shares -- and thus higher profits -- as the stocks' prices decline. This

incentive, however, is not unique to GFL's situation. All short sellers

receive higher profits as the stock's price declines. Indeed, these higher

profits in the face of declining prices are why traders 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 replacement stock to cover

the borrowed shares, thus allowing them to pocket the difference.

Colkitt's differentiation between GFL and other short sellers based on

the structure of the National Medical and EquiMed notes 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 traders are likewise

guilty of manipulating markets in violation of Section 10(b). Of course,

this position is untenable, for as already explained, short selling is

perfectly lawful.

26

sales caused a 17.5% decline in National Medical and an

18.5% decline in EquiMed,9 and that these price slumps

allowed GFL to obtain an additional 11,658 shares of

National Medical and an additional 27,882 shares of

EquiMed from Colkitt -- are equally unavailing. Once again,

short selling, even in large volumes, is not in and of itself

unlawful and therefore cannot be regarded as evidence 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 debt), 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 groundless.

Because a court is required to indulge only reasonable

inferences, we reject Colkitt's last three requested

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 inference is

unreasonable as GFL needed to use four brokers because

none of them had enough shares necessary for GFL to

_________________________________________________________________

9. As already noted, see supra note 1, Colkitt greatly exaggerates

EquiMed's price decline. The price of EquiMed on the 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 undermines his theory that

short sales are manipulative because they depress prices. He writes: "It

is reasonable and makes economic sense to infer that short selling drives

down share prices, because each short sale is, itself, a `sale,'

increasing

supply . . . ." Reply Br. of Appellant at 15 (emphasis added). In other

words, Colkitt believes that short sales are manipulative because they

increase the stock's supply and drive down its price. This, of course, is

true (assuming demand remains constant), but it is also true for all

stock sales, whether they are from long positions or short positions. The

rationale of Colkitt's theory would lead to the absurd result of outlawing

any sales practice that increases a security's supply and consequently

may affect its price. Colkitt fails to understand that increasing the

supply of stocks by selling them on the open market in legitimate

transactions to real buyers does not artificially affect prices and

therefore

cannot be manipulative.

27

borrow to carry out all of its short sales, which is 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 to lock in

the notes' 17.5% and 18.5% profit spreads. Colkitt offers

expert testimony that GFL's short sales could not have been

part of a legitimate hedging strategy because too much time

elapsed between the short sales and the exchange

demands. The expert avers that if GFL were only trying to

protect itself against declining prices after it made its

exchange demand, it could have eliminated that "delivery

risk" by selling short during the five-day period before the

exchange demand, thus locking in the sale price during the

same period the average closing price would be determined.

Because GFL waited so long after the short sales to make

its exchange demands, the expert contends GFL was not

simply hedging against slumping prices, but was

"increas[ing] the likelihood of increasing profits through

artificially (and temporarily) lowering the price of EquiMed."11

Br. of Appellant at 16-17 (quoting Expert Report of

Professor Steven R. Grenadier P 20. (App. 000860-000861)).

Accepting as true Grenadier's position that GFL could

have hedged against all risk by selling short during the five-

days prior to the exchange demands, a court reasonably

could infer that GFL not only sought to protect itself, but

also endeavored to reap further profit from the stocks'

declining prices by selling short. To infer that these

"premature" short sales were executed to manipulate

prices, however, would be an unreasonable leap. Indeed,

Grenadier admits in his deposition that he does not have

an opinion about whether GFL's short sales artificially

depressed the prices of EquiMed stock. See Grenadier Dep.

at 37 (App. 001016). Therefore, although it may be

reasonable to infer from Grenadier's report that GFL's short

_________________________________________________________________

11. Grenadier mentions only EquiMed because GFL sold National

Medical short during the five-day period prior to its exchange demands

to the stock. Therefore, even under Grenadier's theory, GFL's short

trades of National Medical qualify as a legitimate hedging strategy.

28

sales were intended not only to hedge against declining

prices but to profit from them, it would be unreasonable to

infer that GFL's short sales were deceptive or manipulative,

especially considering that the expert concedes that he does

know whether the trades had the effect of manipulating the

prices.12

Finally, in the words of the district court, Colkitt's last

requested inference amounts to "baseless and desperate

mudslinging." Colkitt asserts that GFL was sued twice "for

engaging in manipulative short selling" thus evidencing that

it engaged in that type of conduct with regard National

Medical and EquiMed stock. Br. of Appellant at 35. GFL

responds that it was not even involved in Global Intellicom,

Inc. v. Thomson Kernaghan & Co., No. 99-CIV-342, 1999

WL 544708 (S.D.N.Y. July 27, 1999). Instead, the case

involved a former employee whose allegedly unlawful

conduct occurred after he left GFL. GFL also asserts that

the action in JTS Corp. v. GFL Advantage Fund, Ltd. was

dismissed in the early stages of the litigation after it filed

for Rule 11 sanctions against the plaintiff. Based on GFL's

averments, it would be entirely inappropriate to grant

Colkitt's requested inference that these two lawsuits are

evidence of GFL's alleged market manipulation in this case.

At bottom, the core of Colkitt's argument is premised on

his belief that short selling artificially depresses prices and

presumably should be banned as a market manipulation.

Unfortunately for Colkitt, however, short selling is lawful,

and courts have held that short selling, even in massive

volume, is neither deceptive nor manipulative when carried

out in accordance with SEC rules and regulations. See

_________________________________________________________________

12. Other portions of Grenadier's report also appear to undermine such

a conclusion. In particular, Grenadier endorses the conclusions of

Harvard Business School's Paul Asquith and Lisa Meulbroek that short

trading would have an impact on the value of the securities if the

number of shares sold short constituted 2.5% or more of the total

outstanding shares. See Grenadier Dep. at 80-81 (App. 001017-001018).

In this case, GFL sold short a total of 78,700 shares of EquiMed, which

constituted only .275% of EquiMed's 28,589,717 outstanding 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.

29

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

a claim of market manipulation, Colkitt must present

evidence that GFL engaged in some other type of deceptive

behavior in conjunction with its short selling that either

injected inaccurate information into the marketplace or

created artificial demand for the securities. Colkitt has

offered nothing but evidence that GFL engaged in lawful

short sales of National Medical and EquiMed, which alone

is insufficient to prevail on a claim of market manipulation

in violation of Section 10(b) and Rule 10b-5.

Another reason why Colkitt's market manipulation claim

fails is because he has not met the scienter requirement by

offering evidence that GFL engaged in short sales for the

purpose of artificially depressing the prices of National

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 recklessness

standard for liability under Section 10(b). He contends that

GFL's conduct constitutes "an extreme departure from 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 recklessness

includes: GFL's "powerful economic incentive" to depress

the stocks' prices; "voluminous scholarly evidence" that

GFL's short sales would convey a "negative impression" of

the companies; the dramatic drop in the stocks' prices

during the period of GFL's short selling; the additional

39,540 shares that GFL "extracted" from Colkitt because 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 strategy;

and GFL's having been sued twice for similar conduct.

In essence, Colkitt recycles his arguments that he

advanced in support of his contention that GFL's short

trades were manipulative and deceptive. Some of this

evidence and the requested inferences to be taken

therefrom already have been discredited -- GFL's use of

multiple brokers, whether GFL's short sales were a

legitimate hedge strategy, and the alleged lawsuits against

30

GFL for engaging in short selling -- and the rest of the

evidence and inferences are, once again, general attacks on

the practice of selling short -- the powerful incentive to

depress prices, the negative impression of the company

conveyed by short sales, the actual drop in National

Medical and EquiMed prices, and the additional shares GFL

obtained because of the declining prices. All that this

information proves is that GFL engaged in the lawful

practice of selling stock short and that these short sales

may or may not have affected the price of National Medical

and EquiMed stock. This evidence neither establishes that

GFL's short sales were manipulative nor demonstrates that

GFL executed the trades for the purpose of depressing the

stocks' prices. Perhaps, if Colkitt had offered evidence that

GFL's short sales violated SEC rules (for instance, if GFL

failed to cover properly the short sales in violation of Rule

10a-2, or if GFL made short sales below the last sales price

in violation of Rule 10a-1), Colkitt might have been able to

establish that GFL's conduct was intentionally or recklessly

manipulative or deceptive. In the absence of evidence that

GFL engaged in any wrongful conduct, however, Colkitt's

claim of market manipulation must fail. Therefore, we will

affirm summary judgment in favor of GFL with respect 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 EquiMed

stock through short sales. GFL responds that it had no

duty to disclose its intent to engage in short sales and that

Colkitt has not established that he either relied on this

alleged omission of fact or suffered a cognizable injury 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) with

31

scienter; (3) in connection with the purchase or sale of

securities; (4) upon which plaintiffs relied; and (5) that

plaintiffs' reliance was the proximate cause of their injury."

Weiner v. Quaker Oats Co., 129 F.3d 310, 315 (3d Cir.

1997) (citation and internal quotations omitted). The parties

apparently agree that the third element has been

established, as there is no dispute that the alleged fraud

was related to the purchase or sale of National Medical and

EquiMed securities. Therefore, Colkitt must establish

genuine issues with respect to the following elements:

omissions of material fact, reliance, cognizable injury, and

scienter.13

2. Evidence Supporting Colkitt's Claim of Securities

Fraud

Colkitt asserts that GFL concealed from him two critical

pieces of information that constitute omissions of material

fact: (1) GFL's intention to sell short National Medical and

EquiMed stock; and (2) GFL's actual short sales of the

stock. Colkitt maintains that GFL had an affirmative duty

to disclose this information because it was material 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 issue?

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 material, there is

no liability under Rule 10b-5." Staffin v. Greenberg, 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 have because

of some relationship of trust and confidence between the

parties, such as when one party is a fiduciary, corporate

insider, or "tippee." See Chiarella v. United States, 445 U.S.

222, 229, 100 S.Ct. 1108, 1115 (1980). The Supreme Court

has determined that "[a]n omission of fact is material if

_________________________________________________________________

13. Colkitt submits the same evidence of scienter in support of both his

securities fraud claim and his market manipulation claim. See supra pp.

30-31.

32

there 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, 2132

(1976)). Materiality is a mixed question of law and fact and

should be decided as a matter of law "[o]nly when the

disclosures or omissions are so clearly unimportant that

reasonable minds could not differ." In re Craftmatic Sec.

Litig., 890 F.2d 628, 641 (3d Cir. 1990).

Colkitt's securities fraud claim falters for at least one and

possibly two reasons. To start with, he failed to present any

evidence that GFL intended to engage in short sales at the

time it loaned the money to Colkitt. See In re Phillips

Petroleum Secs. Litig., 881 F.2d 1236, 1245 (3d Cir. 1989)

(stating that "a statement of intent need only be true 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 debt-for-

stock exchange price would be "based upon the accurate,

unbiased and untainted market price quoted by the stock

market." Br. of Appellant at 48. Colkitt explains that

Section 10(b) and Rule 10b-5 impose a "duty to disclose

any material facts that are necessary to make disclosed

material statements, whether mandatory or volunteered,

not misleading." Craftmatic, 890 F.2d at 641. He asserts

that GFL's implicit guarantee that the exchange price would

be based upon prevailing market forces "was rendered

grossly misleading by GFL's failure to disclose that it

intended to short sell EquiMed and National Medical." Br.

of Appellant at 48-49.

We must reject Colkitt's argument for it is premised on

the misguided notion that short sales distort markets and

thus produce inaccurate, biased, and tainted market prices.

As already explained, short sales executed in accordance

with SEC rules and regulations not only are lawful, but also

33

do 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. See Sullivan

& Long, 47 F.3d at 864. Contrary to Colkitt's assertion,

GFL's short sales did not render its guarantee misleading,

and GFL consequently did not have a duty to disclose to

Colkitt its intention to engage in short selling. Therefore,

because Colkitt failed to create a genuine issue with respect

to GFL making an omission of material fact, we will affirm

summary judgment in favor of GFL with respect to the

securities fraud claim.

D. REINSTATEMENT OF FEDERAL SECURITIES LAW

COUNTERCLAIMS

Colkitt argues that the district court erred when it

dismissed his amended counterclaims for lack of specificity

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, as we

have explained, Colkitt failed to create genuine issues of

material fact as to certain elements of his corresponding

affirmative defenses, and thus, his counterclaims must fail

on the merits as well.

E. VIOLATIONS OF PENNSYLVANIA LAWS

1. Securities Claims

Section 1-508 of the Pennsylvania Securities Act bars the

basing of certain suits on contracts that violate state

securities laws. See Pa. Stat. Ann. tit. 70,S 1-508 (1994).

Section 1-401 of the Pennsylvania Securities Act prohibits

the use of any "device, scheme or artifice to defraud" and

the omission of any "material fact necessary in order 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 recipient

of a misrepresentation [to] avoid the contract by showing

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, these

provisions are "functionally identical" to Section 29(b) and

34

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

Communication Serv. Group, Inc., 155 F. Supp. 2d 310, 321

n.14 (E.D. Pa. 2001) ("Section 401 of the Pennsylvania

Securities Act is modeled after Rule 10b-5 of the federal

securities laws, and requires virtually the same elements of

proof."). Therefore, Colkitt's state securities and common

law fraud claims fail for the same reasons his federal

securities claims fail.

2. Breach of Contract Claim

Colkitt argues that GFL is barred under Pennsylvania law

from enforcing the notes because GFL committed a material

breach of the contracts by refusing to accept Colkitt's

prepayment, even though the notes contain no language

prohibiting prepayment. Colkitt claims that he notified GFL

in late December 1996 and early January 1997 that he

would prepay all outstanding principal and interest on the

notes, but GFL improperly rejected Colkitt's request for

prepayment in hopes of declaring the notes in default and

collecting millions of dollars in penalties.

GFL responds that it did not outright reject Colkitt's

request for prepayment, but conditionally accepted the

prepayment offer while reserving its rights to dispute the

balance due. GFL not only disagreed with Colkitt about the

amounts due, but refused to allow Colkitt to dictate the

terms of any prepayment. Because of its conditional

acceptance of Colkitt's offer, GFL maintains that whether or

not the notes permitted prepayment is not at issue. 14 GFL

also argues that Colkitt's failure to tender any prepayments

-- or any payments, for that matter -- undermines his

position that he was attempting to make a full prepayment

of outstanding principal and interest.

_________________________________________________________________

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

do

not permit GFL either to reject or accept conditionally 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 court concluded that

"GFL's acceptance while reserving its rights to the disputed amount does

not constitute a breach of contract." Id.

35

More 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 default on

his interest obligations, he failed to maintain a pledge of

securities in escrow, and he neglected to file required

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 breaches,

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 amount of

$21,121,989.39. Colkitt argues that the damages should 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 right to collect

anything but principal and interest when it rejected

Colkitt's prepayment offer. As already addressed, he

maintains that GFL's refusal to accept prepayment

constituted a breach of contract and that if GFL had

accepted his prepayment offer as it allegedly was obligated

to do, he would have owed only $11,740,198. Colkitt

cannot prevail on this argument, however, as he never

actually tendered the $11,740,198 prepayment. Depriving

GFL of the interest and penalties due on a balance that

Colkitt never paid would reward him unfairly for his breach

by allowing him to hold onto GFL's money interest free 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 unenforceable

penalty "that is disproportionate to the value of the

performance promised or the injury that has actually

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 profit GFL

would have been able to earn had it exchanged all of the

debt for shares of National Medical and EquiMed and sold

the shares on the market. He also insists that adding 14%

36

"default interest" to the premiums is simply punitive and

constitutes unenforceable liquidated damages.

We reject Colkitt's request to reduce the damage award.

Both the "premiums" and the "default interest" compensate

GFL for distinct economic losses suffered by GFL as a

result of Colkitt's breach. The 20.5% and 22% "premiums"

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 would have

been if GFL had been able to convert all of the debt into

National Medical and EquiMed stock. In contrast, the

"default interest" is intended to compensate GFL for

damages it incurred since Colkitt's breach -- namely, the

deprivation of its money over the past four and a half years.

Not only were these provisions included in contracts that

were negotiated at arm's length, but contrary to Colkitt's

assertions, they also would restore GFL to the position that

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

IV. CONCLUSION

For the foregoing reasons, we will affirm the orders 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