Unpublished Disposition, 940 F.2d 1533 (9th Cir. 1986)

MEMORANDUM^* 

Edwin G. Hubert, Darryl G. Greenamyer and Greenamyer Engineering & Technology ("GE & T") appeal the judgment entered following a jury verdict against them in this Rule 10b-5 securities fraud, common law fraud and negligent misrepresentation case. The jury awarded eleven investor-plaintiffs compensatory and punitive damages totalling $4,015,000. Greenamyer and GE & T also appeal the verdicts awarding damages to Developak Corporation. The appellants argue that the district court erred in denying their motions for JNOV or, in the alternative, for a new trial. Because we agree that the district court erred in admitting certain highly prejudicial evidence against the appellants, we reverse the judgment in favor of the investors and remand for a new trial. We affirm the judgment in favor of Developak.

BACKGROUND

A. Campen et al. v. Hubert, Greenamyer and GE & T

Eleven individual investors in Fin-Tech Limited Partnership brought this suit against Hubert, the attorney who prepared the Private Placement Memorandum ("PPM") and served as Fin-Tech's general partner, Greenamyer, the president and co-owner of Greenamyer Engineering & Technology ("GE & T"), and GE & T, the company with which Fin-Tech contracted to carry out the research and development project for a price of $2.1 million. The suit, alleging violations of Rule 10b-5 and common law fraud and negligent misrepresentation, was based on a subcontract entered into between GE & T and Developak Corporation calling for Developak to perform at least some (the appellees contend all) of the work GE & T originally contracted to do. The appellees allege that this subcontract was negotiated before Fin-Tech was fully-subscribed, that its existence was a material fact that the appellants had a duty to disclose, and that because of this nondisclosure, the appellants earned an illicit profit of nearly one million dollars.

The jury returned a general verdict in favor of the plaintiffs, and awarded compensatory damages totalling $765,500, and punitive damages against Hubert in the amount of $750,000, against Greenamyer in the amount of $1,500,000, and against GE & T in the amount of $1,000,000. The district court denied motions by each appellant for JNOV and, in the alternative, for a new trial. We review the denial of a motion for a new trial for an abuse of discretion. Hard v. Burlington Northern R.R., 812 F.2d 482, 483 (9th Cir. 1987).

At trial, the district court admitted, over the appellants' objections, Exhibits 57 and 58, which were the Findings of Fact and Conclusions of Law and the Judgment in an adversarial bankruptcy proceeding called In re Mediscan Research, Inc. Paragraph 9 of Exhibit 57 was blown up, shown to the jury, and read by one of the plaintiffs; it states in part:

The failure to disclose these material facts is a violation of Section 12(2) ... and Section 10(b) ..., and makes the [note] hereafter unenforceable and void based on the violations of federal securities law and the fraud and concealment by American Principals, Mr. Hubert, Mr. Greenamyer and GE & T.

By way of limiting instruction, the judge read Federal Rule of Evidence 404(b) to the jury, and stated that "Exhibits 57 and 58 are admitted for limited purpose only." RT 5-19-89 at 57-58. We review the admission of evidence under Rule 404(b) for an abuse of discretion. United States v. Brown, 880 F.2d 1012, 1014 (9th Cir. 1989).

In order for evidence to be admissible under this Rule, the judge must determine both that it is relevant to a material, non-character issue, Huddleston v. United States, 485 U.S. 681, 686 (1988), and that, under Rule 403, its probative value is not substantially outweighed by its prejudicial effect. Id. at 691; United States v. Marsh, 894 F.2d 1035, 1038 (9th Cir. 1989), cert. denied, 110 S. Ct. 1143 (1990). While the judge did not perform the requisite balancing test on the record, our own review of the trial transcript persuades us that the prejudicial value of this evidence so far outweighs its probative value that it was an abuse of discretion to admit it.

First, Greenamyer and Hubert were not even parties to the Mediscan proceeding. As far as we can tell, the "factual finding" indicating that they were guilty of securities fraud was a gratuitous recital that had nothing to do with the outcome of that dispute. Moreover, there was absolutely no evidence introduced in the Fin-Tech trial to prove or even to hint that the prior fraud actually occurred, or that Hubert and Greenamyer were in any way involved in it. See Huddleston, 485 U.S. at 689 ("similar act evidence is relevant only if the jury can reasonably conclude that the act occurred and that the defendant was the actor"). Combined with the inflammatory manner in which the appellees' counsel used the evidence, and the lack of a meaningful limiting instruction, we have no trouble concluding that its admission was an abuse of discretion. And because we cannot say with confidence that it is more probable than not that the error did not affect the verdict, this error was not harmless. Shad v. Dean Witter Reynolds, Inc., 799 F.2d 525, 529 (9th Cir. 1986). Accordingly, the district court abused its discretion by denying the motions for a new trial; the judgments in favor of the investor-appellees must be reversed, and the matter remanded for a new trial.

The appellants raise numerous other issues on appeal. While we do not base our decision to reverse the judgments on these other issues, we will discuss those that may be implicated should this matter be retried.¹ 

The appellants contend that the district court erred in imposing an evidence preclusion sanction that prevented them from introducing any evidence indicating how GE & T spent the money paid to it by Fin-Tech. We review sanctions ordered under Federal Rule of Civil Procedure 37 for an abuse of discretion, and we will not reverse absent a definite and firm conviction that the district court made a clear error of judgment. Halaco Engineering v. Costle, 843 F.2d 376, 379 (9th Cir. 1988). We review for clear error a district court's findings of fact in connection with a motion for sanctions. Id.

The district judge exercised considerable restraint and made very clear to the appellants his willingness to work with them to resolve the dispute. Only after repeated warnings did the judge "conclude that those records are in fact in existence, and that the defendants have willfully and flagrantly failed to produce them." We have no reason to believe that this finding was clearly erroneous, and so we hold that the evidence preclusion sanction was not an abuse of discretion. We do agree with the appellants, however, that it was improper for the judge to inform the jury about the sanction. The sanction itself suffices to punish the appellants for their misdeeds, and any mention of that sanction to the jury can only distract it from deciding the issues before it.

The appellants next argue that the district court abused its discretion by refusing to admit a letter from the IRS to Fin-Tech indicating that no change would be made in the Partnership's 1983 tax return. Whatever the letter's potential relevance, we think it clear that the letter constitutes inadmissible hearsay, as the appellants offered it to prove the truth of the matter asserted, namely that Fin-Tech spent the money on research and development. Moreover, the letter would require a good deal of interpretation to establish its relevance. The judge did not abuse his discretion in refusing to admit it.

The appellants also contend that the judge abused his discretion by allowing one of the plaintiffs, who happens to be a securities attorney, to testify as an expert witness on the meaning of various provisions of the federal securities laws. It was highly improper to admit this testimony. Whether or not the witness' testimony included misstatements of the law, it is the judge's duty to instruct the jury on matters of federal law. See Vucinich v. Paine, Webber, Jackson & Curtis, Inc., 803 F.2d 454, 461 (9th Cir. 1986). The court abused its discretion in admitting this expert testimony.

5. PUNITIVE DAMAGES AND THE GENERAL VERDICT FORM

The appellants argue that it was error for the trial judge to submit a general verdict form to the jury where punitive damages were available on only one (i.e. common law fraud) of the three causes of action. The jury verdicts did not indicate the basis for the punitive damage awards. In response to the appellants' objection to the general form, the judge assured them that he would instruct the jury as to which theories would support an award of punitive damages. The judge's failure to give the promised instructions was error; the jury must be informed on which charges it can award punitive damages. And while the party desiring a special verdict form has the burden of requesting one before the jury retires, see Fed. R. Civ. P. 49(a); Burgess v. Premier Corp., 727 F.2d 826, 831 (9th Cir. 1984), the appellants' failure to do so here resulted from their reliance on the judge's assurance that the jury instructions would address their concerns.

Lastly, we address the appellants' contention that there is insufficient evidence to support a verdict in favor of the appellees on any of the theories of liability. Hubert, who prepared the PPM, argues that there was no "secret oral agreement" between GE & T and Developak at the time the partnership shares were being sold. Further, Hubert contends that the PPM indicated that GE & T was authorized to enter into subcontracts relating to the research and development work. So as not to influence a possible retrial, we do not delineate here the specific factual allegations upon which we rely in concluding, after a careful review of the record and the entire trial transcript, that the appellees have presented evidence sufficient to support their theory of liability as to appellant Hubert.

Because Greenamyer and GE & T did not actually prepare the PPM, their liability under the federal securities laws must be based either on a theory of primary liability as a seller of partnership shares, or on a theory of secondary liability as controller and/or aider and abettor of Hubert's primary liability. Again, so as not to interfere with any potential future proceedings in this matter, we simply announce our conclusion that the appellees have presented sufficient evidence to support a finding of liability as to Greenamyer and GE & T on each of the three theories alleged in the complaint.

The second matter we consider in this appeal concerns a third-party dispute between GE & T and Greenamyer, and Developak, the subcontractor. After several initial attempts to state claims against Developak for contribution and indemnity, GE & T filed its second amended third-party complaint. The judge again granted Developak's motion to dismiss GE & T's claims for indemnity and contribution, but let stand a state law claim for breach of contract. Following that ruling, Developak answered the third-party complaint, and filed a counterclaim for breach of contract against GE & T, and a cross-claim for intentional interference with contractual relations against Darryl Greenamyer personally.² 

Developak argued to the district court as late as the morning the trial began that the court lacked subject matter jurisdiction to try the third-party dispute between it and GE & T and Greenamyer. When the judge refused to dismiss them from the case, Developak proceeded to defend against the breach of contract claim, and to prosecute the claims it asserted in the cross- and counterclaims. The jury found in favor of Developak on GE & T's third-party complaint, and also awarded Developak $134,350 on the counterclaim against GE & T, and $360,000 on the cross-claim against Greenamyer. GE & T and Greenamyer appeal those verdicts, arguing that the district court lacked subject matter jurisdiction to hear the claims, and that the verdicts are not supported by sufficient evidence.

Greenamyer and GE & T, having fought to bring Developak into this case, argue on appeal that the district court in fact lacked jurisdiction to entertain the claims that ultimately resulted in nearly $500,000 in jury verdicts against them. They contend that the third-party claims were pendent party claims, and that since there was no independent federal subject matter jurisdiction over Developak, the court did not have the authority to hear the state law claims alleging breach of contract and intentional interference with contractual relations.

Whether the district court had subject matter jurisdiction is a question we review de novo. Kruso v. Int'l Tel. & Tel. Corp., 872 F.2d 1416, 1421 (9th Cir. 1989), cert. denied, 110 S. Ct. 3217 (1990). However, once we determine that ancillary or pendent jurisdiction exists, we review the district court's decision to exercise that jurisdiction for an abuse of discretion. United States v. City of Twin Falls, Idaho, 806 F.2d 862, 868 (9th Cir. 1986), cert. denied sub nom. Twin Falls v. Envirotech Corp., 482 U.S. 914 (1987).

The appellants fundamentally mischaracterize the nature of the district court's jurisdiction in this matter. The discussions in the parties' briefs to this Court concerning pendent party jurisdiction and the Supreme Court's recent ruling in Finley v. United States, 490 U.S. 545 (1989), are, quite simply, irrelevant. The issue before the Court in Finley was whether federal courts can exercise jurisdiction over state common law claims asserted against a third party as to whom there is no independent basis for federal subject matter jurisdiction by a plaintiff who has properly invoked the jurisdiction of the federal courts in the primary action. The Court in Finley held that, lacking express statutory authorization, a court cannot exercise jurisdiction over such pendent parties.

Under Finley, then, the appellants' argument would make sense only if GE & T were the original plaintiff, because then its attempt to assert a breach of contract claim against Developak would arguably constitute the sort of pendent party jurisdiction the Court held may only be exercised where authorized by statute. In fact, however, in all of the pleadings and hearings concerning the district court's jurisdiction over Developak, neither the parties nor the court ever disputed that the court's jurisdiction over these third-party claims was premised on the court's ancillary jurisdiction under Federal Rule of Civil Procedure 14.³  In relevant part, that Rule reads:

(a) When Defendant May Bring in Third Party. At any time after commencement of the action a defending party, as a third-party plaintiff, may cause a summons and complaint to be served upon a person not a party to the action who is or may be liable to the third-party plaintiff for all or part of the plaintiff's claim against the third-party plaintiff.

Fed. R. Civ. P. 14(a). In this case, GE & T, the "defending party" in the main action, first tried to state a claim against Developak for indemnity and contribution, but eventually rested its attempt to shift liability on a breach of contract theory. Rule 14 requires that there be some sort of derivativeness or nexus between the primary liability--here, federal securities and common law fraud--and the basis for the attempt to assign third party liability before the court can exercise ancillary jurisdiction. See City of Twin Falls, 806 F.2d at 867; Stewart v. American Intern. Oil & Gas Co., 845 F.2d 196, 199-200 (9th Cir. 1988). But we have never held that such derivativeness must take the form of an indemnity or contribution claim. Here, GE & T's theory of third-party liability was that the investors' harm resulted not from fraud on the part of the appellants, but rather from Developak's breach of the subcontract. This attempt to shift the liability for the investor's loss to Developak establishes the sort of derivativeness that Rule 14 requires; accordingly, we conclude that the district court did not abuse its discretion in exercising jurisdiction over these third-party claims.

It remains only for us to address Greenamyer and GE & T's contention that there is insufficient evidence to support the jury's verdicts in favor of Developak on the third-party claims. As to the claim and counterclaim for breach of contract, upon which the jury awarded Developak $134,350, we agree with Developak that the jury had before it sufficient evidence to conclude that GE & T's actions in stopping payment to Developak in June 1985 and in denying Developak employees access to the requisite facilities amounted to a breach of the subcontract. Likewise, the record reveals that Developak presented evidence from which the jury could conclude that Greenamyer was personally responsible for the actions at the July 2, 1986 partners' meeting at which Developak's special interest was effectively cancelled. The verdicts in favor of Developak on the third-party claims are therefore affirmed.

CONCLUSION

Because of the erroneous and prejudicial admission of the Mediscan evidence, the district court abused its discretion in denying the appellants' motion for a new trial. Accordingly, the judgments against the appellants in favor of the investor-appellees are REVERSED, and we REMAND the matter for a new trial. The judgments entered on the verdicts in the third-party dispute in favor of Developak are AFFIRMED.