The U.S. Court of Appeals for the Sixth Circuit recently affirmed the dismissal of a lender's RICO claims asserted in connection with a borrower's default on a $5 million dollar loan.
In so ruling, the Sixth circuit held that:
1- The "fairly traceable" inquiry required for constitutional standing is jurisdictional, and distinct from the "proximate causation" element required to properly plead and prove a claim;
2- RICO claims generally are not available to creditors following a corporate default, agreeing with several other federal appellate courts.
A copy of the opinion is available at: Link to Opinion
A limited liability company ("lender") invested in startup company ("borrower") the purportedly had valuable intellectual property. The borrower was seeking to raise $26 million dollars to retire existing debt, cover future operating expenses, and take measures needed to begin production. Lender agreed to loan the borrower $5 million dollars. ("Loan") The loan was conditioned on the borrower securing the rest of the $26 million dollars and the loan would be secured by the borrower's intellectual property.
Prior to the lender and borrower closing on the loan, the lender learned that another entity ("third-party lender") already obtained an interest in the borrower's intellectual property. This posed a problem for the lender because the third-party lender's interest was secured by the intellectual property, and the third-party lender's interest was senior to the lender's. Therefore, lender agreed to allow the borrower to pay $3.3 million to the third-party lender to pay off the third-party lender's loan and ensure that the lender had the first secured position on the borrower's intellectual property.
As time passed, the lender allegedly became wary of the borrower's business operations. The lender alleged that it learned the borrower actually only owed the creditor $2.2 million and that the shareholders of the borrower and the third-party lender were the same parties. Furthermore, according to the lender, the borrower did not disclose to the lender that the borrower licensed out their intellectual property to a separate entity and received no funds for the licensing agreement. Beyond the payoff to the third-party lender, the borrower also chose not to draw down the lender's line of credit to the borrow, and never purchased the equipment needed to begin production.
The lender alleged that the principal of the borrower owned a separate consulting company ("consulting company") and improperly diverted business opportunities to his consulting company for the principal's own personal benefit. A proxy war over control of the borrower and allegations of intellectual property theft further added to the turmoil of the borrower who at one point was losing $500,000.00 per month.
Eventually, the borrower defaulted on the loan. As a result, the lender filed various lawsuits in state and federal court. In this case filed in federal court, the lender sued nine (9) defendants: two shareholders of the borrower, two employees of the borrower, the consulting company, the creditor, and the principals of the creditor ("defendants").
The lender alleged the defendants' actions violated the federal Racketeer Influenced and Corrupt Organizations Act ("RICO") for engaging in a pattern of racketeering activity. The lender alleged that the defendants committed: two acts of bank fraud, one act of transactions involving money derived from that bank fraud, one act of trade secrets misappropriation, and one act of wire fraud.
Defendant moved to dismiss for failure to state a claim. The trial court granted defendants' motion to dismiss and this appeal followed.
As an initial matter, the Sixth Circuit reviewed the lender's standing to sue. As you may recall, the U.S. Supreme Court requires a party standing in a lawsuit to satisfy the three elements: (1) an injury in fact that is (2) fairly traceable to the defendant's conduct and (3) likely to be redressed by judicial action. Spokeo, Inc. v. Robins, 578 U.S. 330, 337–38 (2016).
The defendants argued that the lender's allegations did not show injury that that "fairly traceable" to the defendants' alleged conduct, because the lender's alleged injuries were "merely the indirect result of defendants' alleged fraud, financial misconduct, and trade secrets misappropriation". The argued that "courts have used the phrase 'RICO standing' when describing the requirement that a RICO plaintiff show a proximate connection between its injury and the defendant's conduct for purposes of pleading and proving a viable RICO claim." See, e.g., Lerner v. Fleet Bank, N.A., 318 F.3d 113, 129 (2d Cir. 2003), abrogated on other grounds by Lexmark Int'l v. Static Control Components, Inc., 572 U.S. 118, 127 (2014).
The Sixth Circuit disagreed, holding that "[w]hile proximate causation is an element of a RICO plaintiff's cause of action, ... it is not a jurisdictional requirement."
Thus, the Sixth Circuit ruled the lender had standing to sue all but one defendant because the complaint properly alleged that the defendants made misrepresentations in acquiring the loans and then engaged in financial misconduct and trade secret misappropriation, which resulted in borrower's default and harmed the lender's standing as a creditor. As a result, the allegations in lender's complaint were sufficient to show a traceable connection between conduct and injury as to most of the defendants.
However, the Sixth Circuit held that the lender did not have standing to sue the consulting company because the lender's lawsuit did not allege that the consulting company's actions reduced the borrower's capitalization or ability to repay the lender.
RICO creates a private cause of action for civil litigants when "[a]ny person injured in his business or property by reason of a violation of section 1962" may sue for treble damages and attorney's fees. 18 U.S.C. § 1964(c). Section 1962 lists the prohibited activities that may ultimately violate the statute. 18 U.S.C. § 1962.
To properly plead a violation of the RICO statute a plaintiff must allege: (1) two or more predicate racketeering offenses, (2) the existence of an enterprise affecting interstate commerce, (3) a connection between the racketeering offenses and the enterprise, and (4) injury by reason of the above. See Moon v. Harrison Piping Supply, 465 F.3d 719, 723 (6th Cir. 2006); Frank v. D'Ambrosi, 4 F.3d 1378, 1385 (6th Cir. 1993).
The RICO plaintiff must be able to plead at least two of those five predicate acts, and, from the foundation of those two acts, the remaining elements of a RICO claim. If these facts are properly pled, a plaintiff can meet its burden to state a RICO claim. See 18 U.S.C. §§ 1961(5), 1962.
The Sith Circuit also recited that "proximate cause, as an aspect of RICO's "by reason of" standard, has been understood to require a RICO plaintiff to show that the defendant's racketeering offense 'led directly to the plaintiff's injuries", and that "RICO's directness requirement elevates a plaintiff's burden by requiring more than a showing of mere foreseeability, the crux of common law causation principles." In addition, the Sixth Circuit noted, the "'by reason of' standard precludes recovery where a plaintiff's injuries are merely the 'derivative or passed-on' result of the alleged racketeering activity."
The lender alleged that the defendants committed five (5) separate predicate racketeering offenses: two acts of fraud against a financial institution, transactions using money derived from that fraud, trade secrets misappropriation and wire fraud.
However, the Sixth Circuit pointed out that the lender only alleged that it "incurred injuries due to a cascading series of wrongful acts committed by defendants to harm" the borrower, which was not enough to meet the "by reason" of causation standard for RICO claims.
More importantly, the Appellate Court noted, "the injury a creditor suffers due to a corporation's default caused by another party's actions is considered derivative, not direct, for purposes of RICO causation. In that scenario, the acts of racketeering target the corporation, not the creditor." Thus, the Sixth Circuit continued, a "RICO claim is customarily unavailable to creditors following a corporate default."
Explaining its ruling, the Sixth Circuit stated that, "[if there is any proper plaintiff to assert claims for the wrongdoing alleged by [lender], RICO's causation principles suggest that it is [borrower]. After all, [borrower], as the 'immediate victim" of defendants' alleged violations, 'can be expected to vindicate the laws by pursuing [its] own claims", and that "[h]olding otherwise, it bears noting, would dramatically expand RICO's scope."
The lender tried to raise two additional arguments on appeal. First, the lender argued that since the lender's security interest in the borrower's intellectual property vested, the misappropriation of the trade-secrets led to a direct injury. Second, the lender argued that they properly alleged multiple acts of wire fraud and together these acts established a pattern of racketeering activity.
However, the lender did not properly raise these issues at the trial court, and therefore the Court of Appeals did not consider these issues on appeal.
Therefore, the Sixth Circuit affirmed the trial court's dismissal of the lender's RICO claims.
Ralph T. Wutscher
Maurice Wutscher LLP
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