Petition for Writ of Certiorari — Colkitt v. GFL Advantage Fund, Ltd.

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011393 MAR 182002

No. —__ o FFIGE OF THE CLERK

Jn the

Supreme Court of the United States

Douc as R. COoLkITT,

Petitioner,

GFL ADVANTAGE Funp, LTp.,

Respondent.

On PETITION For Writ OF CERTIORARI

To Tue UnNitep STATES Court OF APPEALS

For Tue Tuirp Circuit

PETITION FOR WRIT OF CERTIORARI

Marcy L. CoLkitt

Counsel of Record

Marcy L. Corkrrr & AssociaTEs, P.C.

P.O. Box 607

INDIANA, PA 15701

(724) 463-3570

Counsel for Petitioner

BECKER GALLAGHER LEGAL PUBLISHING, INC.,

CINCINNATI, OHIO 800-890-5001

II.

QUESTIONS PRESENTED

Are entities that have been incorporated under

the laws of the British Virgin Islands either

“citizens” or “subjects” of a foreign state, so

as to give rise in cases brought by such entities

in federal court to subject matter jurisdiction

under Art. Ill, § 2 of the United States

Constitution and 28 U.S.C. § 1332(a)(2)?

Should a federal court of appeals grant a

timely petition for rehearing in light of a

recent controlling decision and clarification of

law from this Court that was not considered by

the court of appeals in rendering its decision

and that is contrary to its judgment and

opinion?

PARTIES TO THE PROCEEDINGS

Petitioner

Petitioner is Douglas R. Colkitt, an

individual citizen of the United States.

Douglas R. Colkitt was the Defendant in the

United States District Court for the Middle

District of Pennsylvania, and the Appellant in

the United States Court of Appeals for the

Third Circuit.

Respondent

Respondent is GFL Advantage Fund,

Ltd., a British Virgin Islands corporation.

Respondent was the Plaintiff in the United

States District Court for the Middle District of

Pennsylvania, and the Appellee in the United

States Court of Appeals for the Third Circuit.

Questions Presented

Parties to the Proceedings

Table of Contents

Table of Cited Authorities

Opinions Below

Statement of Jurisdiction

Constitutional and Statutory Provisions Involved .....

Statement of the Case

Reasons for Granting the Writ

II.

TABLE OF CONTENTS

The Proceedings Below ...........

Subject Matter Jurisdiction .........

This Court Granted a Writ of

Certiorari in Chase Manhattan to

Resolve the Same Important Questions

of Alienage Jurisdiction Presented

ee Are ee re et a

Lack of Subject Matter Jurisdiction

Can be Raised for the First Time in

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III. | The Decision of the Court of Appeals

is Contrary to This Court’s Subsequent

Clarification of § 10(b) of the Exchange

ee cee Nee cede oad sateseubanes 9

PE Disease ae ae eee ea eae 15

Appendix

YE Perr rere ee ee rire App. la

PEE ooo oe oars ee App. 3a

EE aha st ke ek Va ee App. 50a

I «as 4 oe a 4 App. &3a

gg Pe re ee ee are App. Illa

RE 85a bo wba ee oe a App. 11l6a

NEE 5 o'6 ss eee woe ee ee App. 128a

TABLE OF CITED AUTHORITIES

Cases:

American Fire & Casualty Co. v. Finn,

341 U.S. 6(1950) 2.2... ee ee ee ees 7,8

Blue Chip Stamps v. Manor Drug Stores,

421 U.S. 723 CASTS) . ww eee ew eences 10

California v. LaRue,

409 U.S. 109 (1972)... 2... eee ee ee 7

Chase Manhattan Bank v. Traffic Stream (BVI) Infrastructure,

Lid.,

122 S. Ct. 803, 70 U.S.L.W. 3317 (Jan. 4, 2002)

Pre er ree ~ oss eue ae

Chase Manhattan Bank v. Traffic Stream (BVI) Infrastructure,

Lid.,

251 F.3d 334 (2d Cir. 2001) ....-------> 5, 6

In Re Craftmatic Sec. Lit,

890 F.2d 628 (3d Cir. 1989) ....-----++:: 14

Grove v. First Nat’l Bank of Herminie,

489 F.2d 512 (3d Cir. 1974) .....--- eee: 15

In re: GFL Ultra Fund Ltd.,

64 S.E.C. Docket 1956, 1997 WL 330419 *2

(Jame 19, 1997) ee ee Haw cenees 13

Insurance Corp. of Ireland, Ltd. v. Compagnie des

Bauxites de Guinee,

456 U.S. 694 (1982)... 2... eee ee 7,8

Koehler v. Dodwell,

152 F.3d 304 (4" Cir. 1998) ............. 5

Mansfield, C. & L.M.R. Co. v. Swan,

SEE USD. SIP CHO co cece dectsceeeeus 8,9

Mills v. Electric Auto-Lite Co..,

Te UE Bie Cle 8 + 0 2664-00 15

Southern Cross Oversees Agencies, Inc. v. Wah Kwang

Shipping Group, Lid.,

181 F.3d 410 (3d Cir. 1999) ............ 4,5

Sundstrand Corp. v. Sun Chemical Corp.,

553 F.2d 1033 (7" Cir.),

cert. denied, 434 U.S. 875 (1977) .......... 15

The Warf (Holdings) Ltd. v. United Int'l. Holdings, Inc.,

121 S. Ct. 1776 (2001) ..... 3, 4, 10, 11, 12, 14

United States v. Huckabee,

eh ol. Peeeereree rer eee 9

Wilson v. Humphreys (Cayman) Ltd. ,

916 F.2d 1239 (7 Cir. 1990)... .......... 5

Constitution and Statutes:

Article III, § 2 of the United States Constitution ..... l

5 USA... O Pee aie ee eae ckuWeaeen ee aes 1,9

IS U.S.C. O FUEE 0 6 06 cba eeaeue nee eee 10

tS U.S.C. Be exe oc 6 656 e eee 1, 15

BUSBC. 3 TRS <i wei sense ee l

BUS. GOURD 0s cs eerusen ease 5, 6,7

MUSLC. © TRO + <4 ke eek eee 1, 4,6

, %§ X* Sk S PPPCTeTEST TET TT Cy Te ee 8

Securities Exchange Act of 1934................ 2

Douglas R. Colkitt respectfully requests that this Court

issue a writ of certiorari to review the judgment entered in

this case by the United States Court of Appeals for the Third _

Circuit.

OPINIONS BELOW

The decision of the court of appeals denying the

petition for rehearing and rehearing en banc is unreported and

is reproduced at App. A at la. The opinion of the court of

appeals on the merits is reported at 272 F.3d 189 (3d Cir.

2001), and is reproduced in App. B at 3a. The opinions and

orders of the United States District Court for the Middle

District of Pennsylvania are unreported and are reproduced in

App. C at 50a, 81a, 83a, 109a.

STATEMENT OF JURISDICTION

The opinion of thé United States Court of Appeals for

the Third Circuit was issued November 16, 2001. A timely

petition for rehearing and rehearing en banc was denied by

that court on December 21, 2001. Although subject matter

jurisdiction is contested, this Court has jurisdiction to review

the court of appeals’ order under 28 U.S.C. § 1254(1).

CONSTITUTIONAL AND STATUTORY

PROVISIONS INVOLVED

U.S. Const. Art. III, § 2 is reproduced in App. E at

11 1a.

28 U.S.C. § 1332(a)(2) is reproduced in App. E at

112a.

15 U.S.C. § 78j(b) is reproduced in App. E at 113a.

15 U.S.C. § 78cc(b) is reproduced in App. E. at 114a.

STATEMENT OF THE CASE

A. The Proceedings Below

This case arises from two loans together totaling $13

million made by GFL Advantage Fund, Ltd. (“GFL”), a

corporation under the laws of the British Virgin Islands, to

Douglas R. Colkitt, a Pennsylvania resident at the time the

loans were made. The notes representing the loans were

exchangeable into shares of common stock owned by Colkitt

in two small capitalization companies - EquiMed, Inc.

(“EquiMed”) and National Medical Financial Services

Corporation (“National Medical”). The notes gave GFL the

option of purchasing Colkitt’s shares of EquiMed and

National Medical stock in exchange for retiring the debt

represented by the notes at an “exchange price” based upon

the future market price of the stocks. The lower the market

price on the date GFL demanded exchange, the more shares

Colkitt would have to sell GFL to retire the same dollar

amount of debt (because each share would be worth less).

GFL sued Colkitt in the United States District Court

for the Middle District of Pennsylvania for defaulting on the

notes. Colkitt asserted affirmative defenses and counterclaims

under the anti-fraud provisions of the federal and state

securities laws, including §§ 10(b) and 29(b) of the Securities

Exchange Act of 1934 (“Exchange Act”), and for common

law fraud. Colkitt made two types of claims - market

manipulation and securities fraud. | Colkitt’s market

manipulation claim alleged that GFL had engaged in an

unlawful scheme of short selling EquiMed and National

Medical stock just prior to the dates GFL demanded exchange

of the debt for stock for the purpose of depressing the market

price and forcing Colkitt to sell more shares under the notes.

Colkitt’s securities fraud claim alleged that, regardless of any

market manipulation that may have occurred, GFL unlawfully

failed to disclose that (a) GFL intended to short sell the stocks

at the time it entered into the exchangeable notes, and (b)

GFL had in fact short sold thousands of shares just prior to

each demand by GFL to exchange the debt for Colkitt’s

shares.

The district court granted GFL’s motion for summary

judgment, entering judgment against Colkitt and in favor of

GEL in the amount of $21,121,989.39. The court of appeals

affirmed. As to Colkitt’s market manipulation claim, the

court of appeals ruled that even though GFL sold short 78,700

shares of EquiMed and 62,500 shares of National Medical in

the period prior to demanding exchange of the debt for stock,

Colkitt’s claim fails because he did not produce evidence that

these short sales injected inaccurate information into the

market. 272 F.3d at 210-212. As to Colkitt’s securities fraud

claim, the court of appeals ruled that even though Colkitt

created a genuine issue of fact that GFL’s short sales

depressed share prices and caused Colkitt to sell GFL

additional shares for no additional consideration, GFL did not

have a duty to disclose the short sales to Colkitt. Id. at 206

n.6 & 213-14. The court of appeals reasoned that GFL had

no such duty because the short sales did not produce

inaccurate or tainted market prices for EquiMed and National

Medical. Id.

Colkitt sought rehearing and rehearing en banc only as

to his securities fraud claims. Colkitt argued that the court of

appeals decision is contrary to this Court’s recent unanimous

decision in The Warf (Holdings) Ltd. v. United Int'l.

Holdings, Inc., 121 S. Ct. 1776 (2001), which was decided

after the appellate briefs were filed and was not considered by

the court of appeals in rendering its decision. The Warf

clarifies the law under § 10(b) of the Exchange Act by

establishing that there is a duty to disclose information that

makes a securities option contract, such as the exchangeable

notes, misleading even if the concealed information had no

affect upon the market price of the underlying securities. By

ruling that there was no duty to disclose because market prices

had not been artificially tainted, the court of appeals failed to

consider, as required by The Warf, that the short sales misled

Colkitt about the value of the notes themselves as opposed to

the value of the underlying stocks.

The court of appeals denied Colkitt’s petition for

rehearing and rehearing en banc without opinion and refused

to reconsider its ruling in light of The Warf.

B. Subject Matter Jurisdiction

At no time during the proceedings below did either the

parties, the district court, or the court of appeals question

subject matter jurisdiction. All of GFL’s claims arise under

state law, and GFL invoked federal alienage jurisdiction in its

complaint under 28 U.S.C. § 1332(a)(2) as a citizen or subject

of a foreign state suing a resident of Pennsylvania.

A challenge by Colkitt to subject matter jurisdiction

during the proceedings below was foreclosed by a then-

controlling decision of the Third Circuit in Southern Cross

Oversees Agencies, Inc. v. Wah Kwang Shipping Group,

Ltd., 181 F.3d 410, 418-19 (3d Cir. 1999). In that case, the

Third Circuit ruled that entities incorporated under the laws

of British Dependent Territories are “subjects” of the United

Kingdom for purposes of 28 U.S.C. § 1332(a)(2) and may sue

in federal courts. The British Virgin Islands, where GFL was

incorporated, is, like Hong Kong, a British Dependent

Territory. See, Chase Manhattan Bank v. Traffic Stream

(BVI) Infrastructure, Ltd., 251 F.3d 334, 337 (2d Cir. 2001).

Hence, under Southern Cross, subject matter jurisdiction

under § 1332(a) would be present in the instant case and not

subject to challenge in the district court.

Two weeks after the court of appeals denied Colkitt’s

petition for rehearing, this Court called into doubt the Third

Circuit’s decision in Southern Cross by granting a writ of

certiorari in Chase Manhattan Bank v. Traffic Stream (BVI)

Infrastructure, Ltd.. The United States Court of Appeals for

the Second Circuit in that case held that British Virgin Islands

corporations like GFL are neither “citizens” nor “subjects”

of the United Kingdom for purposes of alienage jurisdiction

and that federal courts lack subject matter jurisdiction under

28 U.S.C. § 1332(a) to entertain suits initiated by them. Id.

251 F.3d at 337. This is at odds with the Third Circuit in

Southern Cross and the assumption of jurisdiction in this case,

as well as the Seventh Circuit in Wilson v. Humphreys

(Cayman) Ltd., 916 F.2d 1239, 1243 (7th Cir.1990), cert.

denied, 499 U.S. 947 (1991), and the Fourth Circuit in

Koehler v. Dodwell, 152 F.3d 304, 308 (4th Cir.1998). On

January 4, 2002, this Court granted a writ of certiorari in

Chase Manhattan to resolve this circuit split and consider this

important question of federal subject matter jurisdiction.

Chase Manhattan Bank v. Traffic Stream (BV1) Infrastructure,

Ltd.,122 S. Ct. 803, 70 U.S.L.W. 3317 (Jan. 4, 2002). If

this Court affirms the Second Circuit in Chase Manhattan,

then subject matter jurisdiction will be lacking in the instant

case and the judgment of the district court must be reversed

and the case dismissed.

REASONS FOR GRANTING THE WRIT

This Court Granted A Writ Of Certiorari In

Chase Manhattan To Resolve The Same

Important Question Of Alienage Jurisdiction

Presented Here

On January 4, 2002, this Court granted a writ of

certiorari in Chase Manhattan Bank v. Traffic Stream (BVI)

Infrastructure, Ltd., 251 F.3d 334 (2d Cir. 2001), cert.

granted, 122 S. Ct. 803, 70 U.S.L.W. 3317 (Jan. 4, 2002),

to resolve the identical issue presented by this case: Whether

a British Virgin Islands corporation is a “citizen” or “subject”

of a foreign state for purposes of subject matter jurisdiction

under 28 U.S.C. § 1332(a)(2). The same weighty reasons

that this Court considered sufficient to grant the writ of

certiorari in Chase Manhattan are also present to an equal

degree in this case.

In Chase Manhattan, the question of subject matter

jurisdiction was raised sua sponte by the Second Circuit on

appeal of a district court order granting summary judgment in

favor of a New York corporation and against a British Virgin

Islands corporation that had defaulted on a note in an

aggregate amount of $199,000,000. 251 F.3d at 225-36.

Finding that British Virgin Islands corporations are neither

citizens nor subjects of a foreign state under 28 U.S.C. § 1332(a),

the court of appeals reversed summary judgment and

dismissed the case for lack of subject matter jurisdiction. Id.

at 337. In the instant case, summary judgment was granted in

favor of a British Virgin Islands corporation (GFL) and

against a Pennsylvania resident. The question of whether

British Virgin Islands corporations are citizens or subjects of

ane

a foreign state under 28 U.S.C. § 1332(a) is identical and of

the same consequence.

Certiorari jurisdiction is warranted because there is a

split among the circuits, certiorari has been granted in a

virtually identical case, and the question involves subject

matter jurisdiction and the status of foreign entities under

federal law.

II.

Lack Of Subject Matter Jurisdiction Can Be

Raised For The First Time In This Court

In Insurance Corp. of Ireland, Ltd. v. Compagnie des

Bauxites de Guinee, 456 U.S. 694 (1982), this Court

explained the unique nature of subject matter jurisdiction as

follows:

Subject-matter jurisdiction. . . is an Art. Ill

as well as a statutory requirement; it functions

as a restriction on federal power, and

contributes to the characterization of the

federal sovereign. Certain legal consequences

directly follow from this. For example, no

action of the parties can confer subject-matter

jurisdiction upon a federal court. Thus, the

consent of the parties is irrelevant, California

v. LaRue, 409 U.S. 109 (1972), principles of

estoppel do not apply, American Fire &

Casualty Co. v. Finn, 341 U.S. 6, 17-18

(1951), and a party does not waive the

requirement by failing to challenge jurisdiction

early in the proceedings. Similarly, a court,

including an appellate court, will raise lack of

subject-matter jurisdiction on its own motion.

"[T]he rule, springing from the nature and

limits of the judicial power of the United

States is inflexible and without exception,

which requires this court, of its own motion,

to deny its jurisdiction, and, in the exercise of

its appellate power, that of all other courts of

the United States, in all cases where such

jurisdiction does not affirmatively appear in

the record." Mansfield, C. & L. M. R. Co. v.

Swan, 111 U.S. 379, 382 (1884).

456 U.S. at 702 (footnote omitted).

Insurance Corp. of Ireland is explicit and “without

exception” that subject matter jurisdiction cannot be waived

by the parties. If a lack subject matter jurisdiction appears for

the first time in this Court, then jurisdiction not only in this

Court but also the court of appeals and the district court must

be denied. See also, Fed. R. Civ. P. 12(h)(“Whenever it

appears by suggestion of the parties or otherwise that the

court lacks jurisdiction of the subject matter, the court shall

dismiss the action). Even where the defendant has himself

removed the case from state to federal court, claiming

jurisdiction based on diversity, and loses on the merits, he

may raise a lack of diversity jurisdiction. See, American Fire

& Casualty Co. v. Finn, 341 U.S. 6, 16-19 (1950). In such

a circumstance, the correct procedure is for this Court to

reverse the judgment and remand with instructions to have the

case dismissed:

Usually, where a court has no jurisdictions

[sic] of a case, the correct practice is to

dismiss the suit, but a different rule necessarily

prevails in an appeliate court in cases where

the subordinate court was without jurisdiction

and has given judgment or decree for the

plaintiff, or improperly decreed affirmative

relief to a claimant. In such a case, the

judgment or decree in the court below must be

reversed, else the party which prevailed there

would have the benefit of such judgment or

decree, though rendered by a court which had

no authority to hear and determine the matter

in controversy.

Mansfield, 111 U.S. at 385 (quoting of United States v.

Huckabee, 16 Wall. 414, 435 (1872)).

Certiorari jurisdiction is warranted to determine

whether the judgment of the district court should be reversed

and the case dismissed for lack of subject matter jurisdiction.

iil.

The Decision Of The Court Of Appeals Is

Contrary To This Court’s Subsequent

Clarification Of § 10(b) of the Exchange Act

One of the two decisive issues on the merits below was

whether GFL had a duty under § 10(b) of the Exchange Act,

15 U.S.C. § 78(j)(b), to disclose to Colkitt its intention to

short sell the EquiMed and National Medical stock at the time

it entered into the exchangeable notes - and its subsequent

admitted short sales of those shares prior to each exchange

demand. The court of appeals held that there is no disclosure

obligation because the short sales did not result in tainted

market prices for the EquiMed and National Medical stock.

In The Warf (Holdings) Ltd. v. United Int’] Holdings,

Inc., which was decided after appellate briefing and was not

considered by the court of appeals in rendering its decision,

this Court clarified the disclosure obligations under § 10(b) in

such cases. The defendant in that case argued that it had no

duty to disclose its secret intention not to honor the option

contract because that intention “does not ‘relate to the value

of a security purchase or the consideration paid.’” Id. 121 S.

Ct. at 1781-82 (citation omitted). The Court began its

analysis of the disclosure duty by explaining that courts must

distinguish between the two potential securities involved in

the § 10(b) claim - the underlying stock versus the future

option itself to purchase the stock. The Court observed that

this is consistent with the Exchange Act itself, which defines

“security” to include both “‘any . . . option . . . on any

security’ and ‘any . . . right to. . . purchase’ stock.” Id. at

1780 (quoting 15 U.S.C. § 78c(a)(10) and citing Blue Chip

Stamps_v. Manor Drug Stores, 421 U.S. 723, 751

(1975)(“holders of . . . options, and other contractual rights

or duties to purchase . . . securities” are “‘purchasers’ . . . of

securities for purposes of Rule 10b-5”)).

Having identified the security at issue in the § 10(b)

claim as the option itself rather than the underlying stock, the

unanimous Court rejected the defendant’s argument that it had

no obligation to disclose information that did not impact the

value of the underlying stock:

But even were it the case that the Act covers

only misrepresentations likely to affect the

value of securities, Wari’s secret reservation

was sucha misrepresentation. Tosellanoption

while secretly intending not to permit the

option’s exercise is misleading, becausea buyer

normally presumes good faith. Cf., e.g.,

Restatement (Second) of Torts § 530, Comment

c (1976)(“Since a promise necessarily carries

with it the implied assertion of an intention to

perform [,] it follows that a promise made

without such an intention is fraudulent. ”). For

similar reasons, the secret reservation misled

United about the option’s value. Since Warf

did not intend to honor the option, the option

was, unbeknownst to United, valueless.

Id. at 1782.

The court of appeals below did not consider The Warf

in holding that GFL had no obligation to disclose the short

sales to Colkitt. Consequently, the court of appeals opinion

fails to distinguish between the two different securities

underlying Colkitt’s § 10(b) claims - the EquiMed and

National Medical stocks versus the exchangeable notes

themselves (the option). Most importantly, the court of

appeals opinion fails to consider Colkitt’s claim that GFL’s

failure to disclose the short sales misled Colkitt as to the value

of the option (the exchangeable notes) rather than the

underlying stocks.

Like the option contract in The Warf, there is no

dispute in this case that the exchangeable notes are

“securities” under the Exchange Act because they are option

contracts to purchase securities in the future. The Warf, 121

S. Ct. at 1780. And like the option contract in The Warf,

there can be little dispute that Colkitt was mislead as to the

value of the notes by GFL’s failure to disclose that it was

short selling the stocks and depressing share prices, making

the notes more costly to Colkitt by forcing him to sell

additional shares to retire the same amount of debt. Indeed,

the court of appeals ruled that Colkitt created a genuine issue

of material fact that GFL’s undisclosed short sales depressed

share prices by 18.5% for EquiMed and 17.5% for National

Medical just prior to GFL’s exchange demands. 272 F.3d at

206 n.6. The effect of GFL’s undisclosed short sales was

that, unbeknownst to Colkitt, he would be forced to pay GFL

between 17.5% and 18.5% in additional shares to retire the

same amount of debt. GFL thus reaped increased profits

under the notes, extracting from Colkitt 27,882 more shares

of EquiMed and 11,658 more shares of National Medical than

GFL would have been entitled to receive without the

undisclosed short selling. Under The Warf, GFL did

have a duty to disclose its short sales to Colkitt.'

' As a possible alternate ground for decision, the court of appeals

suggested that Colkitt failed to present evidence that GFL intended

to engage in the short sales at the time of the notes. App. B at 43a.

That simply is not accurate and, even if it were, it does not end the

analysis. Colkitt pointed to two pieces of evidence. The first was

GFL’s own affidavit, which states as follows:

The price of each exchanged share of stock [under

the notes] was “locked in” pursuant to the

aforementioned formula as of the date of the

Exchange Notice. GFL therefore assumed the risk

associated with a subsequent price decrease in the

subject stock. The additional time delay which

resulted from the aforementioned restrictive

legends exacerbated this risk... . This delay

required GFL to engage in a short selling hedge

strategy to minimize the risk.

It is GFL’s practice to review each component of

its portfolio on a regular basis. In addition to the

aforementioned hedge strategy, GFL may at times

sell a stock short if market conditions warrant

and GFL has the right to convert shares but

does not then possess “long” shares its portfolio

to sell. Hence, rather than undertake

numerous, small exchanges, GFL also took a

limited short position in [National Medical] and _

EquiMed in certain instances when it did not

hold the stock long, but price and daily volume

nevertheless presented favorable conditions for a

limited sale of the stock.

(A copy of the Stout Affidavit is reproduced in App. F at 1 16a,

Stout Aff. at {4 14-15)(emphasis added)). This affidavit creates a

genuine issue of fact (if not fully establishes a party admission) that

GFL’s preexisting “practice” was to short sell stocks underlying its

exchangeable notes. The second piece of evidence Colkitt pointed

to, which confirms GFL’s “practice”, was a 1997 SEC decision

against GFL’s sister fund in which the SEC found that of 90 similar

convertible stock transactions, GFL’s sister fund had short sold the

underlying securities in 62 of them. In re: GFL Ultra Fund Ltd.,

64 S.E.C. Docket 1956, 1997 WL 330419 *2 (June 19, 1997).

However, even if GFL had no intention to short sell the

stocks at the time it entered into the exchange notes, GFL was

under a duty to disclose the short sales prior to each exchange

demand it gave to Colkitt. The transaction was not completed

when the notes were entered. The notes actually gave GFL the

right to engage in a series of future transactions in which it could

demand that Colkitt sell stock in exchange for retiring debt in

amounts no less than $100,000 per transaction. (A copy of the

Note relating to the EquiMed shares is reproduced in App. G at

128a, Note at § 2.1). Three months after the notes were entered,

GFL gave Colkitt the first of three different exchange demands for

EquiMed stock; and GFL gave Colkitt the first of six different

exchange demands for National Medical stock four months after the

notes were entered. App. B at 8a. GFL was under an obligation

each time it demanded shares and created a new stock purchase

transaction to disclose the existence of the short sales so as to make

Hence, summary judgment against Colkitt should have been

reversed by the court of appeals, not affirmed.* Certiorari

the exchange demands themselves (which contained new

representations about market price) not misleading. See In Re

Craftmatic Sec. Lit, 890 F.2d 628 (3d Cir. 1989).

The court of appeals held correctly that Colkitt need not

prove reliance and damages to establish his affirmative defenses

under § 10(b) and § 29(b), only his counterclaims. App. B at 28a-

30a, Panel Op. fn. 6. Colkitt did, however, create genuine issues as

to both, as well as scienter.

> The Warf also demonstrates why § 29(b) applies to this case and

voids the notes. The court of appeals held that § 29(b) voids only

contracts made or performed in violation of a provision of the

Exchange Act. App. B at 2la. Colkitt does not dispute this

proposition. The court of appeals went on to hold, however, that

§ 29(b) does not render the exchangeable notes in this case void

because “GFL’s short sales are completely independent of the

parties’ respective obligations under the terms of the notes... .”

Id. (emphasis added). This holding is contrary to The Warf

because it fails to distinguish between the two securities at issue in

this case and Colkitt’s independent market manipulation and

securities fraud claims. Colkitt’s claim that the notes violated §

10(b) because they failed to disclose the short sales was not even

considered by the court of appeals in reaching this conclusion. If

Colkitt proves his securities fraud claim that GFL violated § 10(b)

by failing to disclose the short trades, the notes must, by definition,

be void under § 29(b). This Court explained in The Warf that Rule

10b-5 forbids the use in connection with the purchase or sale of a

security of a “omission of a material fact necessary in order to

make the statements made . . . not misleading.” The Warf, 121 S.

Ct. at 1780 (quoting 17 C.F.R. § 240.10b-5). Using the language

of § 29(b), exchangeable notes containing omissions of material

fact entered in violation Rule of 10b-5 and § 10(b) would have been

jurisdiction is warranted to correct this error and maintain the

uniformity of the Third Circuit's decisions with controlling

Supreme Court precedent.

CONCLUSION

The petition for a writ of certiorari should be granted.

Respectfully submitted,

Marcy L. Colkitt

Counsel of Record

Marcy L. Colkitt & Associates, PA.

P.O. Box 607

Indiana, PA 15701

- (724) 463-3570

Counsel for Petitioner

Douglas R. Colkitt

“made in violation” of the Exchange Act, and each subsequent

exchange demand would have been a “performance of which

involved the violation of” the Exchange Act. 15 U.S.C. § 78cc(b).

See also Mills v. Electric Auto-Lite Co., 396 U.S. 375, 386-87

(1970)(under § 29(b) “the guilty party is precluded from enforcing

the contract against an unwilling innocent party”); Sundstrand

Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1051 (7" Cir.),

cert. denied, 434 U.S. 875 (1977)(securities fraud in violation of

§ 10(b) voids and renders unenforceable option contract under § -

29(b)); Grove v. First Nat'l. Bank of Herminie, 489 F.2d 512 (3d

Cir. 1974)(per curiam)(lender that violates Exchange Act regulation

barred by § 29(b) from recovering deficiency on loan).

APPENDIX A

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 00-2428

D.C. Civ. No. 97-cv-00526

[Filed December 21, 2001]

GFL ADVANTAGE FUND, LTD.,)

a British Virgin Islands Corporation, )

)

DOUGLAS R. COLKITT

Douglas Colkitt, Appellant.

ZZ OO

PRESENT:

BECKER, Chief Judge

SLOVITER, SCIRICA, NYGAARD,

ALITO, ROTH, McKEE, BARRY,

AMBRO, FUENTES, GREENBERG’

and COWEN’, Circuit Judges,

SUR PETITION FOR REHEARING

“As to panel rehearing only.

PR Renate aot cit an aes Sin eabt brindle SR Tas TOT Re sia

The petition for rehearing filed by appellant in the

above-entitled case having been submitted to the judges who

participated in the decision of this Court and to all the other

available circuit judges of the circuit in regular active service,

and no judge who concurred in the decision having asked for

rehearing, and a majority of the circuit judges of the circuit

in regular service not having voted for rehearing, the petition

for rehearing by the panel and the Court en banc, is denied.

BY THE COURT,

/s/

Circuit Judge

Dated: December 21, 2001

———

lie nei Ii Paste ae 0 TONG Ta CA OE

APPENDIX B

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 00-2428

[Filed November 16, 2001]

GFL ADVANTAGE FUND, LTD.,)

a British Virgin Islands Corporation, )

)

DOUGLAS R. COLKITT

Douglas Colkitt, Appellant.

— Oe OS

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.

JUDGES:

‘Before: SCIRICA, GREENBERG and COWEN, Circuit

Judges.

Third Circuit Opinion - 11/16/01

OPINION BY:

GREENBERG

OPINION

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 National

Medical. After unsuccessfully attempting to secure financing

bi ARS SITAR ES NCE aS Oe

Third Circuit Opinion - 11/16/01

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

GEL. 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

Third Circuit Opinion - 11/16/01

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

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

;

Third Circuit Opinion - 11/16/01

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 seiling 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 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. §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

Third Circuit Opinion - 11/16/01

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. §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. |

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 ©

Third Circuit Opinion - 11/16/01

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 GEL 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 ina 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.’ Colkitt argues that GFL

purposely depressed the stock prices so that Colkitt would be

' 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.

Third Circuit Opinion - 11/16/01

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.

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

10a

ee ee

ie le ht ES LOT A SL LEE DARL nb.

le Bathe hid to at ote eT BOS

Third Circuit Opinion - 11/16/01

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.> On April 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

2 The Court dismissed counterclaims 1 (Section 10(b) of the

Security Exchange Act of 1934 and Rule 10b-5 under the Act), Ill

(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) 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 USA.

§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.

lla

Third Circuit Opinion - 11/16/01

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

inforniation 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 finai 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 "there must be

some circumstances beyond the mere occurrence of short

sales to suggest that 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.

Third Circuit Opinion - 11/16/01

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. §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. §1291.’

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. §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. $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

Coikitt 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.

13a

Third Circuit Opinion - 11/16/01

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 imthe

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, 91 L. Ed. 2d 202 (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

14a

Third Circuit Opinion - 11/16/01

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. §78cc(b) (emphasis added). Colkitt argues

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

engaged 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

15a

Third Circuit Opinion - 11/16/01

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 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

16a

Third Circuit Opinion - 11/16/01

Stearns were themselves unlawful... .

‘Under §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." /d. 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 allegediy 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 performance of which

17a

Third Circuit Opinion - 11/16/01

involves the violation of' the statute and the rules and

regulations thereunder." /d. 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 (Sth 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 "rendering voidable those contracts that are either illegal

when made or as in fact performed." /d. 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." /d. at 561.

The court added: -"That these contracts, under different

circumstances, could have been performed without violating

the Act is immaterial." /d.

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Third Circuit Opinion - 11/16/01

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 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 éntailed 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." /d. at 516.

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Third Circuit Opinion - 11/16/01

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 §29(b) of the Exchange Act." /d.

The court explained that "aliowing 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." /d. at 34.

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

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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 Coikitt'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).*

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

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

+ 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.

Third Circuit Opinion - 11/16/01

issues on any of the elements of market manipulation.°

° 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 "the short selling of National Medical presents an interesting

contrast to the short selling of EquiMed." /d. 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 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

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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 "it shall be unlawful for any person . . . to

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. §78j. Rule—10b-5

provides in relevant part that "it shall be unlawful for any

person . . . to employ any device, scheme, or artifice to

defraud." 17 C.F.R. §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 . . .

that, unlike the EquiMed shorts, the National Medical shorts, by

their timing, could at least qualify as a hedge strategy" because they

were made 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.

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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. §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, 64 L. Ed. 2d 611 (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 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, 47 L. Ed. 2d 668 (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.

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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).

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

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Third Circuit Opinion - 11/16/01

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, 51 L. Ed. 2d 480 (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., 430 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, stated, "regardless

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

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Third Circuit Opinion - 11/16/01

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 Jn re Blech Securities

Litigation, 928 F. Supp. 1279, 1298 (S.D.N.Y. 1996)

(citation omitted), directly contradicts GFL's position by

stating that "the 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

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Third Circuit Opinion - 11/16/01

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 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 (Sth 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).°

° 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

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Third Circuit Opinion - 11/16/01

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 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:C V-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,

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Third Circuit Opinion - 11/16/01

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 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

Colkitt clearly created genuine issues as to whether GFL's short

sales affected the prices of National Medical and EquiMed.

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Third Circuit Opinion - 11/16/01

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 artificially depressed

stock prices by getting others to sell 86,100 shares short and

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Third Circuit Opinion - 11/16/01

"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., 1996 U.S. Dist. LEXIS 324, 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," ci

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Third Circuit Opinion - 11/16/01

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 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

information about a firm does not constitute market

misses the mark, however, because conveying negative

33a

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

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Third Circuit Opinion - 11/16/01

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,’ 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,® and that short selling "conveys negative

’ The parties disagree about the standard of review that

should be applied to Colkitt's requested inferences. GFL contends

that the standard 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.

® 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

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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 sales caused a 17.5% decline in

National Medical and an 18.5% decline in EquiMed,” 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

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.

° 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.

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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.'°

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 borrow to carry out all of its short

sales, which is not unusual when dealing with small cap

'0 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. -

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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 "increasing the likelihood of

increasing profits through artificially (and temporarily)

lowering the price of EquiMed.""' 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

'' 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.

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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 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.’

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

"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.

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responds that it was not even involved in Global Intellicom,

Inc. v. Thomson Kernaghan & Co., 1999 U.S. Dist. LEXIS

11378, 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

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-Detravior 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

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Third Circuit Opinion - 11/16/01

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 /n 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." /d. (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 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

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Third Circuit Opinion - 11/16/01

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.

a 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.

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Third Circuit Opinion - 11/16/01

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 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.'*

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.

'3 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.

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Third Circuit Opinion - 11/16/01

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, 63

L. Ed. 2d 348 (1980). The Supreme Court has determined

that "an omission of fact is material if 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, 99 L. Ed.

2d 194 (1988) (quoting TSC Indus., Inc. v. Northway, Inc.,

426 U.S. 438, 449, 96S. Ct. 2126, 2132, 48 L. Ed. 2d 757

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

should be decided as a matter of law "only when the

disclosures or omissions are so clearly unimportant that

reasonable minds could not differ." Jn 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 leaned the money to Colkitt. See Jn 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,

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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 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

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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

l. 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, §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." /d. §1-401(a), (b). Finally,

Pennsylvania common law permits "the recipient of a

misrepresentation [to] avoid the contract by showing that the

misrepresentation was either fraudulent or material."

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Germantown Mfg. Co. v. Rawlinson, 341 Pa. Super. 42, 491

A.2d 138, 141 (Pa. Super. Ct. 1985). As GFL asserts, these

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

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.

Z. 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

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permitted prepayment is not at issue.'* 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.

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.

'* 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." /d.

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Third Circuit Opinion - 11/16/01

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% "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

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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.

49a

APPENDIX C

UNITED STATES DISTRICT COURT

FOR THE MIDDLE DISTRICT

OF PENNSYLVANIA

No. 4: CV-97-0526

[Filed July 17, 2000]

GFL ADVANTAGE FUND, LTD.,

Plaintiff,

DOUGLAS R. COLKITT

Appellant.

JUDGE:

James F. McClure, Jr., United States District Judge.

MEMORANDUM

BACKGROUND:

On April 4, 1997, plaintiff GFL Advantage Fund,

Ltd., commenced this action against defendant Douglas R.

Colkitt, seeking to recover under written agreements pursuant

to which Colkitt borrowed funds from GFL and agreed, inter

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District Court Memorandum and Order - 7/17/00

alia, that GFL would have the right to exchange the principal

amount of the debt for shares of National Medical Financial

Services Corp. (NMFS) and EquiMed, Inc., held by Colkitt.

Colkitt filed a multi-count counterclaim against GFL alleging

that it engaged in a scheme to defraud him by engaging in a

scheme of concentrated short selling of shares in NMFS and

EquiMed. That action would force down the market price and

enable GFL to exchange the debt for shares valued at an

artificially low price, then reap substantial profits when the

price of the shares exchanged rebounded to former levels.

On March 31, 1998, the court adopted, with

modifications, the report and recommendation of the

magistrate judge to whom the case originally was assigned.

Counts I, III, IV, and V of Colkitt's counterclaim were

dismissed without prejudice, based on the lack of specificity

of the allegations pursuant to Fed. R. Civ. P. 9(b). Count II

of the counterclaim was dismissed with prejudice, subject to

a motion for reinstatement should the Third Circuit recognize

a cause of action under Section 17 of the Securities Act of

1933, 15 U.S.C. §77q(a). Count VI of the counterclaim was

dismissed with prejudice, an action which was concluded on

reconsideration to be in error, and the order was corrected to

make the dismissal without prejudice.

On April 20, 1998, Colkitt filed an amended

counterclaim complaint for the purpose of curing the

deficiencies which led to dismissal of the original

counterclaim. We again concluded that the factual allegations

were insufficient to support a claim of fraud, and the amended

counterclaim was dismissed without prejudice.

On April 25, 2000; the court granted a motion by GFL

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District Court Memorandum and Order - 7/17/00

for summary judgment, and denied (1) a motion by Colkitt to

compel a deposition and expert witness disclosures, (2) a

motion by Colkitt for additional discovery, and (3) a motion

by Colkitt to strike the affidavit of Robert D. Cason. We also

directed the parties to provide supplemental briefing on the

issue of damages.

Before the court are a motion by Colkitt for

reconsideration of our Memorandum and Order of Court

dated April 25, 2000, and the parties' supplemental briefs on

damages.

DISCUSSION:

I, STANDARD FOR RECONSIDERATION

"The purpose of a motion for reconsideration is to

correct manifest errors of law or fact or to present newly

discovered evidence." Harsco v. Zlotnicki, 779 F.2d 906, 909

(3d Cir. 1985) (citations omitted), cert. denied, 476 U.S.

1171, 90 L. Ed. 2d 982, 106 S. Ct. 2895 (1986). "Therefore,

a court may properly grant a party's motion for

reconsideration in any of the following circumstances: '(1) the

development of an intervening change in the law, (2) the

emergence of new evidence not previously available, or (3)

the need to correct a clear error of law or prevent a manifest

injustice.'" Jn re TMI Litigation Cases Consolidated Il, 922

F. Supp. 997, 1008 (M.D. Pa. 1996)(Rambo, C.J.; quoting

Cohen v. Austin, 869 F. Supp. 320, 321 (E.D. Pa. 1994);

citations omitted in /n re TMJ). The granting of a motion to

reconsider is an extraordinary remedy and a court should not

do so when the motion is merely a re-styling or rehash of

issues previously presented. McConocha v. Blue Cross and

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District Court Memorandum and Order - 7/17/00

Blue Shield Mutual of Ohio, 930 F. Supp. 1182, 1184 (N.D.

Ohio 1996). A court should consider neither new evidence

nor a new legal theory which could have been presented on

the original motion, taking into account due diligence. /d.

Mere disagreement with the court is a ground for an appeal,

not a motion for reconsideration. /d.

Il. STATEMENT OF FACTS

The facts recited herein have been taken from our

prior memorandum, since no new evidence or factual matter

is the basis for Colkitt's motion. Material which was

bracketed in our prior memorandum for purposes of

explaining our resolution of a dispute related to factual

matters has been omitted.

Colkitt was the founder and majority shareholder of

NMFS, holding approximately 2.8 million of the 7,426,844

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

which time NMFS was trading at approximately $12.875 per

share. EquiMed was created in February, 1996, as the result

of a merger between Colkitt's wholly-owned practice

management firms and Equivision, a publicly held

opthomology' company in which Colkitt owned a 28%

interest. Colkitt owned 20,783,633 shares of the 28,589,717

shares of EquiMed common stock outstanding as of February,

1996. EquiMed was trading at approximately $14.00 per

' GFL uses the word “opthomology” in its statement of

facts, probably referring to ophthalmology. "Opthomology” is not

in either of the dictionaries consulted by the court. THE RANDOM

HOUSE DICTIONARY OF THE ENGLISH LANGUAGE 1358,

1360 (2d ed. 1987); DORLAND'S MEDICAL DICTIONARY

1185, 1187 (28th ed. 1994).

53a

“District Court Memorandum and Order - 7/17/00

share after a contemporaneous Initial Public Offering.

EquiMed decreased in price to $7.75 per share by August,

1996, the date of the GFL/EquiMed transaction.

Despiie his vast stock holdings, including without

limitation his ownership interest in NMFS and EquiMed,

Colkitt sought to obtain additional liquidity in the spring of

1996 in the range of $15-25 million in order to fund his

aggressive entry into unrelated business ventures. Colkitt

approached a number of commercial lenders in his effort to

obtain this financing including, without limitation, ING

Bearings, Bankers Trust, Republic Bank, and G.E. Capital.

However, Colkitt-did not obtain financing from any of these

lenders nor any other commerciai bank or traditional lender

in the amount desired.

Colkitt engaged Wharton Capital Corp. as his agent to

locate financing sources acceptable to Colkitt. The basic

financial parameters of a prospective convertible transaction,

whereby. Colkitt's shares in either NMFS or EquiMed would

be converted into cash, were set by Colkitt before any

potential lenders were identified. Wharton identified GFL as

a potential lender to Colkitt.

On or about May 24, 1996, Colkitt borrowed

$3,000,000.00 from GFL and executed certain transaction

documents setting forth, among other things, Colkitt's

repayment obligations. Said documents included the NMFS

Exchangeable Note, the NMFS Registration Rights

Agreement, and the NMFS Pledge Agreement.

Among other terms, the NMFS note provided GFL

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District Court Memorandum and Order - 7/17/00

after 30 days with the right to exchange an amount up to one

half of the original principal amount of the NMFS Note for

fully paid and non-assessable shares of NMFS common stock

owned by Colkitt. Beginning 60 days after the date of the

NMFS Note, GFL was entitled to exchange the remaining one

half of the outstanding principal amount of the NMFS Note

for such shares of NMFS common stock. The NMFS Note set

the exchange price at 82% of the Average Market Price of

NMFS common stock, as that term is defined in the NMFS

Note. The right to exchange was limited to the outstanding

principal.

Colkitt also agreed to pay interest on the unpaid

principal balance at a rate of 7% per annum, payable on the

first day of each February, May, August, and November,

beginning on August 1, 1996, and at maturity.

On or about August 5, 1996, Colkitt borrowed an

additional $10,000,000.00 from GFL and executed certain

transaction documents setting forth, among other things,

Colkitt's repayment obligations. Said documents included the

EquiMed Exchangeable Note, the EquiMed Pledge

Agreement, and the EquiMed Registration Rights Agreement.

Beginning 60 days after the date of the EquiMed Note, GFL

had the right to exchange up to one half of the original

principal amount of the EquiMed Note for fully paid and non-

assessable shares of EquiMed common stock owned by

Colkitt. Beginning 90 days after the date of the EquiMed

Note, GFL could exchange the remaining one half of the

principal amount of the EquiMed Note for such shares of

EquiMed common stock. The EquiMed Note set the exchange

price at 83% of the Average Market Price of EquiMed

common stock, as that term is defined in the EquiMed Note.

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District Court Memorandum and Order - 7/17/00

The right to exchange was limited to the outstanding

principal.

Colkitt also agreed to pay GFL interest on the unpaid

principal sum at the rate of 4% per annum, payable on the

first day of each February, May, August, and November,

beginning on November 1, 1996, and at maturity.

The Notes provide that Pennsylvania law controls the

Notes and other transaction documents entered into by and

. between Colkitt and GFL. Neither the EquiMed nor the

NMFS transaction documents included any provision which

prohibited or otherwise limited GFL from entering into a

short position in the stock of either NMFS or EquiMed at any

time.

Colkitt received cash from GFL at closing in the

amounts of $3,000,000.00 less broker's commission in

conjunction with the NMFS transaction and $10,000,000.00

less broker's commission in conjunction with the EquiMed

transaction.

In order to allow GFL to sell shares which it was to

receive in exchange for debt under the terms of the NMFS

Note, Colkitt was required to cause NMFS to prepare and file

with the SEC a post-effective amendment to NMFS's

Registration Statement on Form SB-2 within 15 days from the

date of the NMFS Note, or by June 7, 1996. Colkitt failed to

cause NMFS to file such a post-effective amendment with the

SEC within the time required. Colkitt failed to pay interest on

the outstanding principal under the NMFS Note on August 1,

1996, and at any time thereafter. Colkitt failed to maintain in

escrow shares of EquiMed common stock in an amount equal

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District Court Memorandum and Order - 7/17/00

to not less than 150% of the current outstanding principal

balance due under the EquiMed Note, as required by the

transaction documents. Colkitt also failed to honor GFL's

EquiMed Exchange Notice dated January 3, 1997, at which

time GFL attempted to exchange $ 1,430,000.00 of principal

into approximately 500,685 shares of EquiMed common

stock. ‘

NMFS and EquiMed notified GFL on January 9,

1997, that they would no longer honor any further Exchange

Notices because GFL had called a default under the applicable

transaction documents.

The Notes contain cross-default provisions, which

provide that a default under either of the Notes constitutes a

default under the other Note. Colkitt specifically agreed to

pay to GFL, upon default, all unpaid principal then due under

the Notes, all accrued and unpaid interest on the unpaid

principal balance together with an amount equal to 22%

(NMFS) or 20.5% (EquiMed) of the unpaid principal

balances then due under the Notes. Colkitt specifically waived

demand, presentment or notice in the event of a default under

the Notes.

The following exchange requests were submitted to

Colkitt. All were honored except as noted:

Date of Exchange _EquiMed NMFS

September 13, 1996 $ 250,000.00 principal

for 34,130 shares at

$7.32/share

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District Court Memorandum and Order - 7/17/00

Date of Exchange EquiMed NMES

September 19, 1996 $135,000.00 principal se

for 18,726 shares at

$ 7.21/share

October 10, 1996 $ 257,000.00 principal

for 47,081 shares at

$ 5.46/share

November 27, 1996 $ 560,000.00

principal for

150,555 shares

at $3.72/share

December 5, 1996 $ 100,000.00 principal

for 14,845 shares at

$ 6.74/share

December 19, 1996 $ 200,000.00 principal

for 34,588 shares at

$ 5.78/share

January 3, 1997 $1,430,000.00

principal for

500,685 shares

at $ 2.86/share

Dishonored.

January 7, 1997 $ 2,058 ,000.00

principal for 100,223

shares at $ 5.44/share

Withdrawn as moot.

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District Court Memorandum and Order - 7/17/00

Pursuant to the exchange procedures agreed upon by

the parties, GFL would forward to Colkitt a "Notice of

Exchange of Exchangeable Note" which would set forth,

among other things, the exchange date, the dollar amount of

principal balance which GFL sought to exchange, together

with the number of shares which GFL was entitled to receive

in exchange. Upon receiving a Notice of Exchange, it was

agreed that Colkitt thereafter would process said request and

forward instructions designed to release to GFL the

appropriate number of shares. In a number of cases, however,

the actual stock certificates received by GFL bore a restrictive

legend which restricted the subsequent transfer of such shares.

As a result, GFL was often required to take the additional

step of requesting from the applicable transfer agent "clean,"

non-legend shares in exchange for the legended shares.

Whether for this or other reasons, GFL did not receive

physical possession of freely assignable certificates from

Colkitt until approximately 11, 18, 25, 33, 34, and 46 days

after the date of the six honored Exchange Notices.

The price of each exchanged share of stock was

"locked in" at a five-day average of the stock immediately

prior to the date of the Exchange Notice. The risk of a

decrease in the price of the converted stock therefore was

shifted from Colkitt to GFL as of the date of the conversion

request.

According to GFL, in order to hedge against the risk

of a price decrease, and otherwise to take advantage of

current market conditions, GFL entered into the following -

short sales:

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District Court Memorandum and Order - 7/17/00

Date

9/13/96

9/16/96

9/17/96

10/11/96

10/14/96

11/8/96

11/11/96

11/12/96

11/14/96

11/22/96

NMFS

Closing Shares

Price Sold

$10.00 32,500

9.13 15,000

9.25 5,000

8.25 3,000

8.25 7,000

- EQUIMED

Closing Shares

Price — Sold

$5.25 18,400

5.25. 32,500

5.00 16,000

5.25. 8,500

5.13 3,300

Price Change

from Prior Day

+1 3/8

-7/8

+1/8

+1/4

no change

Short Sale

Price

Change

from

Prior Day

10,000-

$5.50

8,400- 5.48

5.38

5.25

5.00

-1/4

no change

-1/4

+1/4

+ 3/8

GFL did not engage in any other short trade, either for

its Own account or in conjunction with any other affiliate or

unrelated third party, except as set forth in the tables above.

The average closing price of NMFS showed an increase

between January, 1996, and May, 1996, but then declined

steadily between May 1996 and January, 1998. The decline

was from a peak of $12.875 on May 1, 1996, to a low of

$0.4375 on January 2, 1998. The average closing price of

EquiMed showed a similar pattern, peaking on February 1,

1996, at $15.00, then declining to a low of $2.4583 on

January 2, 1998.

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SNR TES

Colkitt has no independent knowledge of how many

shares GFL actually shorted in NMFS and EquiMed, and his

suspicions concerning GFL were based, in large part, upon

information which he received "third hand, double hearsay

probably..." Colkitt never disclosed to GFL his alleged

suspicions that GFL was engaged in a manipulative market

scheme of any kind until Colkitt filed his answer, affirmative

defenses and counterclaim in this action on June 5, 1997.

Colkitt attempted to negotiate the prepayment of the Notes in

December, 1996, and January, 1997.

GFL claims damages totaling $20,043,469.73 as of

- December 31, 1999. _

III. PRIOR RULING

The focal point of Colkitt's challenge to our prior

ruling is the following language:

| Both parties cite /n re Olympia Brewing

Co. Securities Litigation, 613 F. Supp. 1286,

1292 (N.D. Ill. 1985), for the principle that

short selling is not illegal per se, but may be

unlawful if it is part of a scheme to manipulate

the market. The court explained:

Furthermore, the court reminds

plaintiffs that short selling is

simply not unlawful, even in

1 large numbers and even if the

trading does negatively affect

the purchase price. Where the

trading volume and prices

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District Court Memorandum and Order - 7/17/00

simply reflect supply and

demand based on_ accurate

market information, this is

lawful market behavior, not

market manipulation. Hence,

evidence of substantial short

selling is mecessary to

plaintiffs’ claims, but certainly

does not prove them. Where

the selling appears in all other

respect to be lawful, the court

will not draw the inference that

an unlawful conspiracy to

manipulate the market price

took place.

Id. at 1296.

Despite the party's lengthy briefs, use

of calculations such as percentages of daily

sales versus monthly salles, etc., the theory

espoused by Colkitt fails for one simple

reason: he has failed to produce any evidence

that the short selling by GFL had any

substantial effect on the price of NMFS or

EquiMed shares. That is, there is a simple

causation problem which undermines all of

Colkitt's arguments.

The decline in the price of NMFS

began in May, 1996, well before the short

sales of that stock by GFL in September,

1996. The decline continued through 1997 and

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District Court Memorandum and Order - 7/17/00

into 1998. The decline in the price of EquiMed

began in February, 1996, again well before

any short sales of that stock by GFL in

November, 1996. Colkitt fails to provide any

evidence 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.

See generally In re Scattered Corp. Securities

Litigation, 844 F. Supp. 416, 420 (N.D. Til.

1994)(market manipulation under Rule 10b-5

refers to practices intended to mislead

investors by artificially affecting market

activity; quoting Santa Fe Indus., Inc. v.

Green, 430 U.S. 462, 476, 51 L. Ed. 2d 480,

97 S. Ct. 1292 (1977)), aff'd sub nom.

Sullivan & Long, Inc. v. Scattered Corp., 47

F.3d 857 (7th Cir.), reh'g en banc denied,

cert. denied sub nom. Harkins v. Scattered

Corp., 516 U.S. 818, 133 L. Ed. 2d 35, 116

S. Ct. 76 (1995).

abe eee Mas

Memorandum and Order of Court dated April 25, 2000, at

21-22.

Stated differently, we concluded that Colkitt's

affirmative defenses necessarily were based on his claim that

GFL's short sales constituted a scheme to manipulate the

market, but his only evidence was the short selling itself. As

the court in Olympia Brewing explained, since short selling is

lawful, it is not permissible to infer from short sales alone that

the party engaging in short sales is engaged in market

pbs cnn Sik, eMac 2» hin pil AO iar ya bi cht

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District Court Memorandum and Order - 7/17/00

manipulation in violation of the securities laws and

regulations.

IV. COLKITT'S ARGUMENTS

In arguing for reconsideration, Colkitt

mischaracterizes the holding of our prior memorandum.

According to Colkitt, we "considered only whether there was

evidence that GFL's short trades caused a movement in share

prices. Finding no evidence, the Court held as a matter of law

that there could have been no manipulative scheme for GFL

to disclose." Brief in Support of Motion for Reconsideration

at 3. Actually, our holding was that, as in Olympia Brewing,

there was no evidence that the short sales affected the price,

so that the short sales alone were not evidence of market

manipulation. Memorandum and Order of Court dated April

25, 2000, at 22-23. Coikitt "fail[ed] to provide any evidence

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." /d. at 22.

Unfortunately, in responding to Colkitt's motion, GFL

"took the bait" and has expended considerable time and

energy responding to Colkitt's arguments regarding the

causation element of a claim under Section 10(b) (15 U.S.C.

§78j(b)) and Rule 10b-5 (17 C.F.R. §240.10b-5). All of that

discussion has little, if anything, to do with the issue before

the court. The question was whether Colkitt had produced

sufficient evidence to support his affirmative defense that

GFL had engaged in market manipulation. Consistent with

Olympia Brewing, we held that evidence of short sales is

insufficient because those sales are lawful. There must be

some circumstance beyond the mere occurrence of short sales

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District Court Memorandum and-Order - 7/17/00

to suggest that the short sales were part of a scheme to

manipulate the market. Since no such circumstances were

present, we concluded that Colkitt's affirmative defense

failed. The parties’ arguments concerning the causation

element of a Section 10(b) claim are misplaced.

Colkitt's segue into the realm of causation is our

statement that "there is a simple causation problem which

undermines all of Colkitt's arguments." Memorandum and

Order of Court dated April 25, 2000, at 21. The "simple

causation problem," which the parties have managed to

complicate beyond all recognition, was the lack of evidence

that the short sales had any effect on the price of the shares at

issue. Absent such evidence, the short sales alone did not

support an inference of market manipulation, and Colkitt's

affirmative defense failed.

Colkitt argues, for the first time, that there was

evidence of other circumstances which, in combination with

the evidence of short sales, supports his contention that the

agreements between the parties are void for fraud (common

law and under the securities laws). First, he contends that

GFL's "unique and direct pecuniary interest" was sufficient

to establish a prima facie case. Brief in Support of Motion for

Reconsideration at 5-6. He cites, id. at 6 n. 1, Crane Co.

Westinghouse Air Brake Co., 419 F.2d 787, 794 (2d Cir.

1969)(correct page is 795), cert. denied, 400 U.S. 822, 27 L.

Ed. 2d 50, 91 S. Ct. 41 (1970), in support of that proposition.

Actually, Crane is distinguishable, and the rule for which

Colkitt cites Crane is incorrect in any event.

In that case, Crane sought a merger with Air Brake,

but the directors of Air Brake opposed the merger and were

65a

District Court Memorandum and Order - 7/17/00

offered assistance by American Standard, Inc., to resist

Crane's takeover attempt. /d. at 790-791. Crane extended a

tender offer for Air Brake stock which was to expire on April

19, 1968, the “critical day" in the take-over battle. /d. at

792. Since the tender offer was an exchange of Air Brake

stock at $50 per share, "the surest way to defeat the Crane

offer was to run the price up to $50." /d. The stock opened on

April 19 at 45 1/4, "giving Crane's tender offer a good

prospect of success." /d.

Meanwhile, American Standard and the directors of

Air Brake had met in special session on April 8 and agreed to

merge the companies. /d. at 791. Air Brake's directors

informed their shareholders of the agreement and solicited

proxies in favor of the merger with American Standard. /d.

Throughout this time, Crane accumulated shares of Air Brake

stock to support its own merger proposal. /d.

At the close of trading on April 18, American

Standard owned 367,000 shares of Air Brake, with a limit of

460,000 shares (10%) due to statutory and accounting

restrictions. /d. at 792. On April 19, Standard engaged in a

series of transactions involving the purchase of Air Brake

stock and sales of the same shares, including an undisclosed

sale of some 100,000 shares. /d. at 792-793. The purchases

and sales represented a loss to American Standard of

$500,000. /d. at 791. "The net result of this buying was to

represent to the public, whose primary source of information

is the tape, that there was a great demand for Air Brake at an

increased value." /d. at 792-793. Stated another way,

"{[American] Standard had ‘painted the tape’ in Air Brake

stock." /d. at 793. The Second Circuit summarized American

Standard's activity as follows:

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District Court Memorandum and Order - 7/17/00

Standard's extraordinary buying here,

coupled with its large secret sales off the

market, inevitably distorted the market picture

and deceived public investors, particularly the

Air Brake shareholders. The effect of these

purchases was to create the appearance of an

extraordinary demand for Air Brake stock and

a dramatic rise in market price, as a result of

which Air Brake shareholders were deterred

from tendering to Crane. Concentrated open

market bidding in a takeover battle may not in

itself violate present laws and regulations, a

question we do not decide here. Standard's

actions here, however, in concealing from the

public--and in particular from the Air Brake

stockholders--the true situation as to the

market it was making in Air Brake stock

resulted in violations of sections 9(a)(2) and

10(b) of the [Securities Exchange] Act.

Id.

In the district court, Crane claimed that the

transactions were illegal purchases of proxy votes and that

there was market manipulation and fraud. The district court

denied relief on both claims, but emphasized the vote

purchasing claim because that was more vigorously pressed

by Crane. On appeal, the Second Circuit did not address the

vote purchasing claim because it was abandoned. On closer

examination of the market manipulation claim, the Second

Circuit reversed. /d. at 791-792. As described above, it

concluded that American Standard plainly had acted with the

intent to raise the price of Air Brake stock by deceiving

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District Court Memorandum and Order - 7/17/00

investors into thinking that there was active trading of, and

demand for, the stock. In short, American Standard had

engaged in market manipulation.

From all of this, Colkitt quotes a single sentence out

of context and argues-that it reflects error by this court. The

sentence is, "When a person who has a ‘substantial, direct

pecuniary interest in the success of a proposed offering takes

active steps to effect a rise in the market’ in the security, we

think that a finding of manipulative purpose is prima facie

established." /d. at 795 (footnote omitted; quoted by Colkitt

in his Brief in Support of Motion for Reconsideration at 6

n.1). Ignored by Colkitt is the next sentence, "Here we have

even more than a motive to manipulate joined with the

requisite series of transactions." Id. (emphasis added). The

"requisite series of transactions" discussed throughout the

opinion refers to the trading of Air Brake shares which raised

the price of the stock, i.e. "active steps to effect a rise in the

market."

There are, in effect, two layers of intent which must

be established in a claim such as that described in Crane. The

party accused of market manipulation first takes some action

which will have an effect on the price of a security, such as

buying shares. Its intent at that point is to complete the

purchase. The question then is whether the purchase will have

an effect on the price of the security such that false

information is provided to the trading public. If the action

taken will cause the price of the security to rise when, under

normal market conditions, it would not rise, and the party

taking that action benefits from the rise, one may infer that

the party's purpose is to manipulate. This second showing is

the other layer of intent to which we have referred, and the

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District Court Memorandum and Order - 7/17/00

sufficiency of the showing is what was at issue before the

Second Circuit in Crane.2 While the Second Circuit called

this second layer the party's "manipulative purpose," it might

also have used the term "fraudulent intent," since the

difference between the two is the same as the difference

between the intent of a party to take an action and the

fraudulent intent by the same party to achieve a desired result

(depriving another of property) through taking the action.

In this case, we do not reach the second layer of intent

because Colkitt never established the first layer. That is, while

it is clear that GFL made short sales, it is not clear that it did

so with the intent to cause a decline in the price of the

securities it purchased. The court in Olympia Brewing, as we

have quoted and with which we agree, held that an intent to

cause the change in price cannot be inferred from merely

engaging in lawful activity such as short sales. There was no

change in the price of the stock at issue in this case which

may be attributed to the short sales by GFL, and Colkitt

pointed to no evidence that GFL's short sales otherwise

injected false information into the market. Colkitt's attempt to

conflate this analysis with that of the Second Circuit, which

presumed the intent to effect a change the price, is

unconvincing.

We conclude, then, that Crane is distinguishable based

on the stage in the analysis which was at issue. Also, it does

not stand for the proposition that an allegedly injured party

establishes a prima facie case merely by claiming that lawful

? There were other issues before the Second Circuit, such

as Crane's standing to assert the claim, which we do not address as

being immaterial for present purposes.

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District Court Memorandum and Order - 7/17/00

activity by a party with a “unique and pecuniary interest"

constitutes fraud.

Colkitt next cites to the fact that GFL engaged in

"extensive" short sales during the relevant period. He quotes

the following passage:

When the volume and price are increased at

times the stock price is particularly important

to the manipulator, this is stronger evidence of

a 10b-5 violation. ...Comparable sales to stop

an increase or to drive down the price would

naturally fall in the same category.

Colkitt's Brief in Support of Motion for Reconsideration at 6

n. 2 (quoting A. Jacobs, Litigation and Practice under 10b-5

§139.03(d) nn. 10, 11; citations omitted and emphasis added

by Colkitt). The same principle applies: Colkitt cannot show

that GFL acted to increase the price, stop an increase, or

drive down the price merely by referring to referring to

lawful activity. There was no effect shown on the price of

either EquiMed or NMFS stock, since the decline began well

before the short sales and continued well after the short sales.

While we recognize that we risk mantric intonation of

this principle, we reiterate: With respect to a claim of market

manipulation, the alleged manipulator's intent to engage in

unlawful activity is not proven with evidence of lawful

activity absent further evidence that the lawful activity is part

of an unlawful scheme because it is not reasonable to infer

unlawful intent from lawful activity alone. Evidence that the

lawful activity added information to the market which

changed the price of the stock to the benefit of a person in a

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District Court Memorandum and Order - 7/17/00

unique position to benefit directly would constitute the

"further evidence" to which we refer.’ When, as in this case,

there is no change in the price, the lawful activity itself cannot

have provided false information to the market, and it is not

reasonable to infer the intent to defraud under these

circumstances.

Colkitt's next argument borders on (and may well

enter the territory of) the frivolous. He argues that "EquiMed

share prices declined during the period...," Brief in Support

of Motion for Reconsideration at 6, and refers to "GFL's own

evidence...," id. at 6 n. 3. The evidence on which Colkitt

now relies was evidence to which he objected at the time of

summary judgment. Memorandum of April 25, 2000, at 18-

19.

The disingenuous argument continues with Colkitt

pointing out that the closing price of EquiMed on December

2, 1996, was $4.1875 per share, down from $5.00-$5.25

during the period between November 8-14, 1996, although he

probably means November 8-22, 1996, the period during

which GFL made its short sales of EquiMed. Memorandum

of April 25, 2000, at 18. What this argument ignores is that

the price already was down from $15.00 per share on

February 1, 1996, and declined to $2.4583 per share on

* We have never, either in our prior memorandum or in this

memorandum, stated that this "further evidence" must be an effect

on the price of the allegedly manipulated shares. As an example,

making a statement about a corporation is lawful activity. However,

a public announcement concerning the corporation which the

manipulator knows to be false and negative might constitute market

manipulation, the falsity and negativity would be the requisite

"further evidence."

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District Court Memorandum and Order - 7/17/00

January 2, 1998. It also ignores the already precipitous

decline of the value of EquiMed stock: On October 15, 1996,

the stock closed at $7.25 per share, but closed at $5.25 on

November 8, 1996. In other words, the decline in price in the

3 1/2-week prior to the short sales by GFL was greater (both

numerically and percentage-wise) than the decline during the

approximately same-length period to which Colkitt refers

($2.00 or 27.6% in the period before the short sales versus

$1.0625 or 20.2% in the period after the short sales began).*

Colkitt's misleading "snapshot" is 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.

Colkitt next points to evidence that short sales are

"commonly used in manipulation schemes..." Brief in Support

of Motion for Reconsideration at 6. This argument presumes

that a manipulation scheme existed, and it is the absence of

proof on this point that is Colkitt's problem. Regardless, that

something is "commonly used" does not mean that it is so

used in any given instance, nor that its use reflects the same

purpose. The very fact that short selling is lawful suggests

that it is not used exclusively for manipulation. To use an

analogy, we suppose that it could be said that firearms are

"commonly used" in murders. It does not follow that the use

of a firearm is evidence of murder. Rather, further evidence

such as a dead body, other forensic evidence, eyewitness

testimony, etc., would be necessary to prove a murder. In the

* These prices are reflected in the chart which we excluded

but summarized because of Colkitt's objection. See Affidavit of

Donald E. Stout, Appendix in Support of GFL's Motion for

Summary Judgment, Exhibit E, at 7.

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same way, the fact that short sales occurred is not evidence of

a scheme of manipulation.

The next argument proffered by Colkitt is that GFL

concealed its identity by using four different brokers for the

short sales. Once again, Colkitt cites Crane and, once again,

Crane is inapposite. The part of the discussion in Crane to

which Colkitt cites, id. at 795-796, refers to the failure of

American Standard to disclose its manipulation to investors as

the basis for a claim of fraud, and the concealment of the

identity of American Standard as evidence of fraudulent intent

is not discussed. In fact, Colkitt's own footnote is inapposite

to the rule he seems to assert: He states that short sellers can

conceal their identities, Brief in Support of Motion for

Reconsideration at 6, then cites authority relating to the

concealment of sales (not identities), id. at6 n. 5. Regardless,

assuming that concealing one's identity as the holder of a

short position may be evidence of an intent to defraud, Colkitt

still has not established the existence of the scheme to do so.

That is, if the value of the stock was affected, the fact that the

short seller hid its identity might be evidence of a purpose to

manipulate because it could reflect consciousness of guilt.

Conversely, however, the absence of any effect, which in turn

means no manipulation, renders the purported hiding of the

short seller's identity meaningless.

Colkitt next argues that evidence consisting of an

expert opinion rebutted GFL's explanation of the short sales

as a legitimate hedging strategy. That GFL does not provide

an explanation for lawful activity which an expert might

consider unwise hardly renders the activity unlawful.

Regardless, the evidence to which Colkitt refers does not

really rebut GFL's proffered explanation. In its reply brief in

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support of its motion for final summary judgment, GFL

pointed out the limits on the expert's opinion and how, when

presented with a hypothetical akin to the situation at hand, the

hedging strategy would be reasonable. Deposition Testimony

of Steven R. Grenadier, Ph.D. (Exhibit B to GFL's Reply

Brief) at 135-136; Reply Brief at 6-7.

Finally, Colkitt states that "GFL and its advisors have

been accused of engaging in the same type of manipulative

short selling schemes in the past." Brief in Support of Motion

for Reconsideration at 7 (citing Global Intellicom, Inc. v.

Thomson Kernaghan & Co., 1999 U.S. Dist. LEXIS 11378,

No. 99 CIV342, 1999 WL 544708 (S.D.N.Y. July 27, 1999).

We must agree with GFL that this assertion constitutes

nothing more than "baseless and desperate mudslinging."

Brief in Opposition to Motion for Reconsideration at 9.

Colkitt refers to a person named Chau who was employed by

an entity related to GFL (not GFL) and left that employment

well before November, 1996. More importantly, the claims

against Mr. Chau were dismissed. Global Intellicom 1999 at

*11. Unsubstantiated accusations hardly constitute admissible

evidence.

Colkitt's citation to Global Intellicom does give rise to

one bit of irony, however, since it provides a basis for an

additional reason for our prior holding. That court pointed out

that the plaintiff could not have relied on any alleged omission

by Mr. Chau and JNC (his then-employer) with respect to the

intention to enter into future short sales. The reason that

where can have been no reasonable reliance was that the

plaintiff included terms forbidding short sales in contracts

with other entities. "At the time of their negotiation, the

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specter of short selling was a concern for both sides." /d. at

*11.

In the same way, Colkitt included terms forbidding

short sales in his agreements with Berckeley Investment

Group, Ltd., also involving debentures convertible for NMFS

stock. Berckeley Investment Group, Ltd. v. Colkitt, No.

4:CV-97-1242, slip op. at 5-7 (M.D. Pa. Dec. 7, 1999).

Those agreements were executed at about the same time that

the instant agreements were executed, and well after Colkitt

had made known his essential terms for financing agreements.

Thus, he cannot have reasonably relied on any omission on

the part of GFL with respect to short sales.

Having reviewed Colkitt's new contentions at length,

we conclude that he has no more evidence to prove his claims

of fraud than on our original consideration, and the motion

for reconsideration will be denied.

V. DAMAGES

In our Memorandum and Order dated April 25, 2000,

we directed the parties to file supplemental briefs relating to

damages because Colkitt did not address the issue in opposing

the motion for summary judgment. The briefs having been

filed, the matter is ready for adjudication.

As a preliminary matter, we reject Colkitt's argument

relating to the time that he purportedly offered prepayment of

all of the principal and outstanding interest. The question of

the prepayment offer was addressed in our memorandum and

in an Order of Court dated November 5, 1999, and we

rejected the notion that GFL's refusal to accept prepayment

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on Colkitt's terms, i.e. without reserving its rights to disputed

sums, constituted a breach of the agreements between the

parties. Memorandum dated April 25, 2000, at 23-24.

The outstanding principal due at this time is

$2,058 ,000.00 for the NMFS note and $9,440,000.00 for the

EquiMed note. There can be no reasonable question that these

sums are owed.

The next item of damages claims by GFL is the

"Premium," representing the amount of money it would have

earned as the discount from the market rate when it tendered

the principal for the shares of stock. This exchange rate or

exchange price was 82% of the Average Market Price of

NMEFS common stock and 83% of the Average Market Price

of EquiMed common stock. These numbers mean that GFL

would have realized a 22% return on its investment

immediately upon conversion of the NMFS stock and a

20.5% return on its investment immediately upon conversion

of the EquiMed stock.° The dollar amount of this premium

would be $451,756.10 for NMFS and $1,933,493.98 for

EquiMed.

Colkitt attacks the inclusion of the premium as

inequitable because GFL would be recovering both

"liquidated damages" and interest at a “default rate"

(discussed below). The premium, however, is not part of a

liquidated damages clause in the sense that term is used in the

cases cited by Colkitt. A liquidated damages clause sometimes

is included in a contract to allow certainty in the calculation

> Reached through the following arithmetic: 18/(100-

18)=0.2195 (NMFS); 17/100-17=0.2048 (EquiMed)

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of damages, which otherwise might be uncertain, should a

breach occur. In this case, had the contract been performed,

GFL would have earned the premium through the conversion

of stock for principal. The premium does not represent an

attempt to quantify an otherwise uncertain amount, and the

premium clauses of the notes simply represent an intention to

preserve the return on investment should there be a default.

In fact, all that the premium clauses do is set forth in the notes

the actual damages which are suffered and which would be

recoverab

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