                                                                                                                           Opinions of the United
2001 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit


11-16-2001

GFL Advantage Fund v. Colkitt
Precedential or Non-Precedential:

Docket 00-2428




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Recommended Citation
"GFL Advantage Fund v. Colkitt" (2001). 2001 Decisions. Paper 265.
http://digitalcommons.law.villanova.edu/thirdcircuit_2001/265


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Filed November 16, 2001

UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

No. 00-2428

GFL ADVANTAGE FUND, LTD.,
a British Virgin Islands Corporation,

v.

DOUGLAS R. COLKITT

Douglas Colkitt
       Appellant

On Appeal from the United States District Court
for the Middle District of Pennsylvania
(No. 4:CV-97-0526)
District Judge: Honorable James F. McClure, Jr.

Argued October 9, 2001

Before: SCIRICA, GREENBERG and COWEN,
Circuit Judges

(Filed: November 16, 2001)

       Peter S. Russ (argued)
       Gregory J. Krock
       Buchanan Ingersoll
       One Oxford Centre, 20th Floor
       301 Grant Street
       Pittsburgh, PA 15219-1410

        Attorneys for Appellee
       Peter Konolige
       Marcy L. Colkitt & Associates, P.C.
       983 The Woods, Suite 618
       Old Eagle School Road
       Wayne, PA 19087

       James P. Kimmel, Jr. (argued)
       P.O. Box 1139
       Kennett Square, PA 19348

        Attorneys for Appellant

OPINION OF THE COURT

GREENBERG, Circuit Judge:

This matter comes on before this court on defendant
Douglas R. Colkitt's appeal from the district court's order
for summary judgment in favor of plaintiff GFL Advantage
Fund, Ltd. against Colkitt entered on April 25, 2000, and
on appeal from an order entered on July 17, 2000, denying
reconsideration of the April 25 order. For the reasons stated
herein, we will affirm the orders of the district court.

I. BACKGROUND

A. FACTUAL HISTORY

Douglas Colkitt, who earned both his medical degree and
MBA from the University of Pennsylvania in 1979, is the
founder and majority shareholder of two small
capitalization medical services businesses -- EquiMed, Inc.
("EquiMed") and National Medical Financial Services
Corporation ("National Medical"). As of February 1996,
Colkitt held 20,783,633 (73%) of EquiMed's 28,589,717
outstanding shares of common stock, and as of May 1996,
he owned 2.8 million (38%) of National Medical's 7,426,844
outstanding shares of common stock. See GFL Advantage
Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and
Order at 4 (M.D. Pa. July 17, 2000).

Beginning in 1996, Colkitt sought financing to pursue
various business ventures unrelated to EquiMed and

                                  2
National Medical. After unsuccessfully attempting to secure
financing from traditional commercial lending institutions,
Colkitt contacted alternative lenders that might be willing
to structure "convertible or exchange transactions,"
whereby Colkitt would be able immediately to convert his
vast stockholdings into cash. In particular, Colkitt
endeavored to borrow money by pledging his common stock
as collateral and providing the lender with the right to
convert or exchange the debt for the shares pledged by
Colkitt.

In the spring of 1996, Colkitt's broker identified GFL
Advantage Fund, Ltd. ("GFL") as a possible lender, and on
May 24, 1996, Colkitt obtained a loan of $3,000,000 from
GFL. Under the terms of the note ("National Medical note"),
GFL had the right after 30 days of the date of the note to
exchange up to $1.5 million of its outstanding principal for
shares of National Medical stock held by Colkitt at an
exchange rate of 82% of the average market price. GFL
could exchange the remainder of the unpaid balance for
shares of National Medical 60 days after the date of the
note. The average market price was computed by taking the
average of the stock's closing prices for the five days
immediately prior to the exchange request. In essence, the
note gave GFL the right to require Colkitt to repay the loan
with National Medical stock valued at a discount of 18% of
the five-day average closing price, thus giving GFL an
immediate paper profit as it would receive stock with a
premium value to repay a debt of a lesser amount.

Several months later on August 5, 1996, Colkitt entered
into a similar transaction with GFL for a $10,000,000 loan.
The structure of the second note ("EquiMed note") was akin
to that of the National Medical note, except the parties
agreed that GFL could convert the debt into shares of
Colkitt's other business, EquiMed, Inc., at an exchange rate
of 83% of the average market price. In addition, GFL could
convert up to $5 million of the outstanding principal after
60 days of the date of the note and could convert the
balance of the principal 30 days thereafter.

Nearly four months after issuing the initial $3,000,000
loan to Colkitt, GFL made its first of six exchange demands
for National Medical stock. On September 13, 1996, GFL

                               3
exchanged $250,000 of debt for 34,130 shares of National
Medical stock at the average market price of $9.20 and an
exchange or conversion price of $7.32. On September 19,
1996, GFL exchanged $135,000 of loan principal for 18,726
shares at an average market price of $9.075 and a
conversion price of $7.21. On October 10, 1996, GFL
converted $257,000 of debt into 47,081 shares at an
average closing price of $6.925 and a conversion price of
$5.46. On December 5, 1996, GFL exchanged $100,000 of
unpaid principal for 14,845 shares at an average market
price of $8.725 and an exchange price of $6.74. On
December 19, 1996, GFL converted $200,000 of debt into
34,588 shares at an average market price of $7.525 and a
conversion price of $5.78. Finally, on January 7, 1997, GFL
demanded an exchange of $545,000 of loan principal for
100,223 shares, but the request was withdrawn after
Colkitt dishonored GFL's earlier exchange demand for
EquiMed stock.

GFL waited until November 1996, more than 3 months
after the date of the EquiMed note, before making its first
exchange demand for EquiMed shares. On November 27,
1996, GFL demanded that Colkitt convert $560,000 in
outstanding principal into EquiMed stock. With a five-day
average closing price of $4.50, GFL received 150,555 shares
of EquiMed at an exchange rate price of $3.72. GFL's next
exchange demand for EquiMed stock occurred on January
3, 1997, when GFL sought to convert $1,430,000 in unpaid
principal, but Colkitt dishonored the request.

Unknown to Colkitt at the time, and on the same day in
September 1996 as GFL's first exchange demand for
National Medical stock, GFL began short selling National
Medical stock. As we have explained:

       Short selling is accomplished by selling stock which
       the investor does not yet own; normally this is done by
       borrowing shares from a broker at an agreed upon fee
       or rate of interest . . . . The short seller is obligated,
       however, to buy an equivalent number of shares in
       order to return the borrowed shares . . . . Herein lies
       the short seller's potential for profit: if the price of
       stock declines after the short sale, he does not need all
       the funds to make this covering purchase; the short

                               4
       seller then pockets the difference. On the other hand,
       there is no limit to the short seller's potential loss: if
       the price of the stock rises, so too does the short
       seller's loss, and since there is no cap to a stock's
       price, there is no limitation on the short seller's risk.

Zlotnick v. Tie Communications, 836 F.2d 818, 820 (3d Cir.
1988). See also 17 C.F.R. S 240.3b-3 (defining short sale as
"any sale of a security which the seller does not own or any
sale which is consummated by the delivery of a security
borrowed by, or for the account of, the seller"); Black's Law
Dictionary 1339 (7th ed. 1999) (defining short sale as the
"sale of a security that the seller does not own or has not
contracted for at the time of sale, and that the seller must
borrow to make delivery"). In other words, short sellers are
betting that the stock price will decline between the time
they sell the borrowed stock and the time they must
"cover," i.e., purchase replacement shares to repay the
borrowed stock. Short selling, which is closely regulated,
see, e.g., 17 C.F.R. S 240.10a-1, is a legitimate trading
strategy for stocks that traders believe are overvalued.

GFL's first short sale of National Medical stock occurred
on September 13, 1996, when it sold 32,500 shares at a
price of $10.00 per share. On September 16, 1996, GFL
sold short 15,000 shares of National Medical at $9.13 per
share. On September 17, 1996, GFL sold short 5,000
shares at $9.25 per share. On October 11, 1996, GFL sold
short 3,000 shares at $8.25 per share. Finally, on October
14, 1996, GFL sold short 7,000 shares of National Medical
at $8.25 per share. GFL sold short a total of 62,500 shares
of National Medical stock over a one-month period.

GFL also sold EquiMed shares short. On November 8,
1996, GFL sold short a total of 18,400 shares of EquiMed
-- 10,000 shares at $5.50 per share and 8,400 shares at
$5.48 per share. On November 11, 1996, GFL sold short
32,500 shares at $5.38 per share. On November 12, 1996,
GFL sold short 16,000 shares at $5.25 per share. On
November 14, 1996, GFL sold short 8,500 shares at $5.25
per share. Finally, on November 22, 1996, GFL sold short
3,300 shares of EquiMed stock at $5.00 per share. Over
this two-week period in November 1996, GFL sold short a
total of 78,700 shares of EquiMed stock.

                               5
GFL explains that it engaged in short sales of National
Medical and EquiMed stock as a hedging strategy against
"delivery risk." Under the terms of the notes, the exchange
price was based on the average closing price during the five
trading days preceding the exchange request.
Consequently, the exchange price was locked in on the date
of the exchange request, thus shifting onto GFL the risk
that the stock's price would drop more than the 17% or
18% discount. In other words, "if the stock price dropped
more than the agreed-upon discount before GFL was able
to sell the exchanged shares, GFL would be in a loss
position." Br. of Appellee at 7. GFL claims it sold short to
protect itself in the event that the price of the stock
declined further after GFL made the exchange request but
before GFL was able to sell the shares.

The theory of Colkitt's case, however, is that GFL sold
National Medical and EquiMed shares short in an effort to
depress the prices of the stocks. Indeed, Colkitt contends
that the market price of National Medical dropped 17.5%
between GFL's first and last short sales of National Medical
stock, and that the market price of EquiMed declined by
18.5% between GFL's first short sale of EquiMed stock and
GFL's first exchange demand.1 Colkitt argues that GFL
purposely depressed the stock prices so that Colkitt would
be forced to exchange more shares to retire the same
amount of debt. He asserts that GFL was able to obtain an
additional 27,882 shares of EquiMed and an additional
11,658 shares of National Medical due to the respective
declines in the stocks' prices.
_________________________________________________________________

1. Inexplicably, Colkitt measures the price decline of EquiMed stock
during the period between GFL's first short sale on November 8, 1996,
and GFL's first exchange demand on November 27, 1996, rather than
between GFL's first short sale on November 8, 1996, and its last short
sale on November 22, 1996. As GFL points out, however, if the price
decline of EquiMed stock is measured during the period between GFL's
first and last short sales, EquiMed's price drop would be approximately
2%. See Br. of Appellee at 36. More specifically, the price of EquiMed on
the day of the first short trade on November 8 was $5.25 per share,
whereas the price on the day of the last short sale on November 22 was
$5.13. See id. at 36 n.13. This $.12 drop represents only a 2.3%
decrease.

                               6
As noted above, Colkitt refused to honor GFL's exchange
request for EquiMed shares on January 3, 1997. Instead,
Colkitt notified GFL in December 1996 and early January
1997 that he intended to prepay all unpaid principal and
interest in cash. Colkitt contends that GFL improperly
rejected his request to prepay the unpaid balance, even
though the notes contemplated such prepayment. GFL
responds that it did not reject outright Colkitt's offer to
prepay, but rather refused to allow Colkitt to dictate the
terms of any prepayment and disagreed with Colkitt about
the amounts due. GFL admits that it does not believe that
Colkitt had a right to prepay, but insists that it"accepted
Colkitt's offer to prepay whatever amount Colkitt believed
was then due, reserving for itself the right to contest the
disputed balance." Br. of Appellee at 13. GFL claims that
Colkitt neither responded to its overtures nor attempted to
prepay or pay any amounts to GFL.

B. PROCEDURAL HISTORY

On April 4, 1997, GFL filed a complaint against Colkitt
alleging breach of his obligations on the National Medical
and EquiMed notes. On June 6, 1997, Colkitt filed an
answer, affirmative defenses, and six counterclaims. The
affirmative defenses and counterclaims alleged, inter alia,
that GFL engaged in securities fraud and market
manipulation in violation of various federal and state
securities laws by temporarily depressing the prices of
National Medical and EquiMed stock through its
concentrated short sales. Colkitt claimed that GFL engaged
in the scheme so that it could exchange debt for shares at
an artificially low price and earn enormous windfall profits
when prices returned to their normal levels. On March 31,
1998, the district court adopted a magistrate judge's
recommendations that Colkitt's counterclaims be
dismissed. The district court dismissed one counterclaim
with prejudice and the balance without prejudice. 2 On April
_________________________________________________________________

2. The Court dismissed counterclaims I (Section 10(b) of the Security
Exchange Act of 1934 and Rule 10b-5 under the Act), III (Section 29 of
the Securities Exchange Act of 1934), IV (Pennsylvania Securities Act),
and V (common law fraud) without prejudice for lack of specificity. The
court dismissed counterclaim II (Section 17 of the Securities Act of 1933)

                               7
20, 1998, Colkitt filed amended counterclaims in an effort
to cure the deficiencies of the original counterclaims, but
on February 2, 1999, the district court again dismissed
Colkitt's inadequately pled counterclaims without prejudice
for lack of specificity.

On April 25, 2000, the district court granted summary
judgment in favor of GFL based largely on the reasoning of
In re Olympia Brewing Co. Securities Litigation , 613 F.
Supp. 1286 (N.D. Ill. 1985). The court concluded that,
because short selling is not an unlawful trading practice, it
would not draw the inference that GFL manipulated the
market price of EquiMed and National Medical stocks
simply because GFL engaged in substantial short selling of
the stocks. The court also determined that Colkitt failed to
present evidence that GFL's short sales had an appreciable
effect on the prices of the stocks. Finally, the court
concluded that even if the short sales did depress prices,
Colkitt failed to show that "the declines in price are
attributable to false information injected into the market by
the short sales and not to information otherwise available
to the market." GFL Advantage Fund, Ltd. v. Colkitt, No.
4:CV-97-0526, Memorandum and Order at 22 (M.D. Pa.
Apr. 25, 2000).

On July 17, 2000, the district court denied Colkitt's
motion for reconsideration and entered final judgment in
favor of GFL. The court clarified its earlier ruling on GFL's
motion for summary judgment, explaining that the evidence
of GFL's short sales alone was insufficient to establish
Colkitt's claims of securities fraud and market
manipulation because selling stocks short is lawful. The
court declared that "[t]here must be some circumstances
beyond the mere occurrence of short sales to suggest that
_________________________________________________________________

with prejudice, subject to reinstatement in the event that we recognize a
private right of action under Section 17 of the Securities Act of 1933, 15
U.S.C. S 77q(a). The court dismissed counterclaim count VI (unjust
enrichment) without prejudice because the equitable remedy of unjust
enrichment is not available when a contract exists between the parties.
Although the court initially dismissed count VI with prejudice, the court
concluded on reconsideration that the order was in error and changed
the dismissal to a dismissal without prejudice.

                               8
the short sales were part of a scheme to manipulate the
market," which Colkitt failed to proffer. GFL Advantage
Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and
Order at 14 (M.D. Pa. July 17, 2000). The court then
proceeded to reject Colkitt's argument that numerous
inferences that he believed should be drawn from the
factual record created genuine issues of material fact that
precluded summary judgment. The court refused to accept
any of Colkitt's proffered inferences -- each of which Colkitt
has raised on appeal -- and reaffirmed its decision that
GFL was entitled to summary judgment as a matter of law.

II. JURISDICTION AND STANDARD OF REVIEW

A. JURISDICTION

The district court had subject matter jurisdiction over
GFL's breach of contract action pursuant to 28 U.S.C.
S 1332 based upon diversity of the parties and the amount
in controversy. The district court entered final judgment in
this case on July 17, 2000, and appellant filed a timely
notice of appeal on August 15, 2000. Therefore, we have
jurisdiction pursuant to 28 U.S.C. S 1291. 3
_________________________________________________________________

3. As noted above, the district court twice dismissed certain of Colkitt's
counterclaims without prejudice for lack of specificity. In some
circumstances, such a dismissal could deprive us of appellate
jurisdiction as "ordinarily we do not have jurisdiction under 28 U.S.C.
S 1291 of an appeal from an order partially adjudicating a case when an
appellant has asserted a claim in district court which it has withdrawn
or dismissed without prejudice." Erie County Retirees Ass'n v. County of
Erie, 220 F.3d 193, 201 (3d Cir. 2000). Our case law, however, allows us
to exercise appellate jurisdiction under 28 U.S.C.S 1291 when the
district court has divested itself of the case entirely. See id. at 202.
Here,
although the district court's orders dismissed Colkitt's counterclaims
without prejudice, the court's summary judgment order effectively barred
Colkitt from re-filing them, for the court concluded that Colkitt's
affirmative defenses -- which were identical to his counterclaims --
failed as a matter of law. Consequently, the court's order granting
summary judgment in favor of GFL terminated the suit so far as the
court was concerned. See Trent v. Dial Med. of Fla., Inc., 33 F.3d 217,
220 (3d Cir. 1994) ("Even dismissals without prejudice have been held to
be final and appealable if they `end [ ] [the] suit so far as the District
Court was concerned . . . .' ") (citation omitted). Therefore, we have
jurisdiction over this appeal.

                               9
B. STANDARD OF REVIEW

We review the district court's grant of summary judgment
de novo and apply the same standard as the district court
applied in the first instance. See Lucent Info. Mgmt., Inc. v.
Lucent Tech., Inc., 186 F.3d 311, 315 (3d Cir. 1999). We
may affirm summary judgment in favor of GFL only if, after
drawing all reasonable inferences from the record in the
light most favorable to Colkitt, "there is no genuine issue as
to any material fact" and GFL is "entitled to a judgment as
a matter of law." Fed. R. Civ. P. 56(c). As the nonmoving
party, Colkitt must create a genuine issue of material fact
by presenting sufficient evidence to permit a jury to find in
his favor. See Anderson v. Liberty Lobby, Inc. , 477 U.S. 242,
248, 106 S. Ct. 2505, 2510 (1986). To defeat summary
judgment, he "cannot rest simply on the allegations in the
pleadings," but "must rely on affidavits, depositions,
answers to interrogatories, or admissions on file." Bhatla v.
U.S. Capital Corp., 990 F.2d 780, 787 (3d Cir. 1993).
Therefore, it will be appropriate to affirm summary
judgment for GFL if we conclude that there is insufficient
evidence for a reasonable jury to return a verdict for
Colkitt.

III. DISCUSSION

A. RESCISSION OF THE NOTES PURSUANT TO SECTION
29

Colkitt contends that the National Medical and EquiMed
notes are unenforceable by reason of Section 29 of the
Securities Exchange Act of 1934 ("Exchange Act") because
GFL violated the anti-fraud provisions under Section 10(b)
of the Exchange Act and Rule 10b-5 promulgated
thereunder. Section 29(b) provides in relevant part that:

       Every contract made in violation of any provision of this
       chapter or of any rule or regulation thereunder, . .. [or]
       the performance of which involves the violation of, or
       the continuance of any relationship or practice in
       violation of, any provision of this chapter or any rule or
       regulation thereunder, shall be void.

15 U.S.C. S 78cc(b) (emphasis added). Colkitt argues that
GFL violated Section 10(b) and Rule 10b-5 when it engaged

                                10
in market manipulation by short selling National Medical
and EquiMed stock in an effort to depress the share prices,
and when it engaged in fraudulent deception by concealing
its plan to short sell National Medical and EquiMed stock.
See Br. of Appellant at 24. Colkitt asserts that the notes are
void and unenforceable under Section 29(b) because the
notes were "made in violation of" Section 10(b) and Rule
10b-5 insofar as (1) they were part of GFL's scheme to
manipulate the market prices of National Medical and
EquiMed stock and (2) they contain omissions of material
fact about GFL's short selling strategy. See Reply Br. of
Appellant at 19.

GFL argues that Colkitt's Section 29(b) affirmative
defense fails for two reasons. First, Section 29(b) is a
remedial provision that is triggered only when another
section of the Exchange Act has been violated. As
addressed below, GFL maintains that it did not engage in
either market manipulation or securities fraud in violation
of Section 10(b), and therefore, there is no underlying
offense to trigger Section 29(b). See infra pp. 17-36. Second,
GFL contends that Colkitt fails to state a proper Section
29(b) defense inasmuch as Colkitt alleges that it is GFL's
short selling, not the National Medical and EquiMed notes,
that is unlawful. GFL argues that only "unlawful contracts,"
not "unlawful transactions" executed pursuant to lawful
contracts, may be rescinded under Section 29(b).

We deal with GFL's second contention first, which is
supported by the limited body of case law on the point. For
instance, in Slomiak v. Bear Stearns & Co., 597 F. Supp.
676, 677 (S.D.N.Y. 1984), plaintiff opened a margin account
and a repurchase account with defendant Bear Stearns. He
purchased millions of dollars of government bonds in his
margin account -- less than 10% with cash and the
remainder with loans by Bear Stearns. See id. When
plaintiff was notified of a margin call on his account and
failed to muster the $155,000 in additional margin
demanded, Bear Stearns liquidated the government bonds
in plaintiff's account. See id. Plaintiff alleged that Bear
Stearns violated Section 10(b) and Rule 10b-16 by failing to
provide him at the time he opened his accounts with a
written statement explaining the terms under which Bear

                               11
Stearns would extend him credit. See id. Based on these
alleged violations, plaintiff sought to rescind all of his bond
transactions pursuant to Section 29(b). See id. at 681. The
court concluded that plaintiff could not rescind the
transactions, explaining:

       The complaint alleges that Bear Stearns failed to send
       plaintiff a written credit disclosure statement in
       violation of Rule 10b-16 at the time he opened his
       accounts; it does not allege that the customer
       agreements establishing his margin and repurchase
       accounts at Bear Stearns were themselves unlawful
       . . . . `[U]nder S 29 of the Exchange Act, only unlawful
       contracts may be rescinded, not unlawful transactions
       made pursuant to lawful contracts.'

Id. at 681-82 (quoting Zerman v. Jacobs , 510 F. Supp. 132,
135 (S.D.N.Y. 1981), aff'd, 672 F.2d 901 (2d Cir. 1981)
(table)). Because Bear Stearns's alleged violation of Rule
10b-16 was "clearly collateral to the contract agreement
governing the account," the court determined that the
firm's failure to provide the written statement to plaintiff
did "not justify rescission of the account agreement itself or
the transactions undertaken pursuant to that agreement."
Id. at 682-83.

In Drasner v. Thomson McKinnon Securities, Inc. , 433 F.
Supp. 485, 488-89 (S.D.N.Y. 1977), plaintiffs maintained
margin accounts with defendant Thomson McKinnon
Securities between 1973 and 1975. Plaintiffs began selling
naked options in 1974 and profited handsomely off the
transactions until 1975, when the market began spiking
upward. See id. Between January and May 1975, plaintiffs
incurred substantial losses on their options until Thomson
McKinnon finally closed their accounts and liquidated their
collateral. See id. at 489. Plaintiffs sought to rescind the
options contracts pursuant to Section 29(b) because
Thomson McKinnon allegedly violated Regulation T by
failing to direct plaintiffs to deposit the required amount of
initial margin in their accounts. See id. The court rejected
plaintiffs' claim, stating that Section 29(b) "only renders
void those contracts which by their terms violate the Act or
the rules and regulations thereunder . . . for it is only such
contracts which are `made in violation of,' or`the

                               12
performance of which involves the violation of' the statute
and the rules and regulations thereunder." Id. at 501-02.
The court explained that even if Thomson McKinnon had
violated Regulation T, Section 29(b) was inapplicable
because the options contracts that plaintiffs sought to
rescind were governed by a valid, lawful contract whose
terms did not violate the Exchange Act or any regulations
promulgated thereunder. See id. at 502.

Colkitt responds to GFL's argument by citing Regional
Properties, Inc. v. Financial and Real Estate Consulting Co.,
678 F.2d 552, 560 (5th Cir. 1982), which challenges
Drasner's narrow construction of Section 29(b). In Regional
Properties, two real estate entrepreneurs brought suit
against their broker and his firm, Financial and Real Estate
Consulting Co. ("Financial"), alleging that the broker had
violated Section 15(a)(1) of the Exchange Act by selling
limited partnership interests for them without having
registered with the SEC as a broker-dealer. See id. at 556.
The entrepreneurs and their affiliated corporations sought
to rescind their agreements with Financial pursuant to
Section 29(b) in light of the broker's violations of Section
15(a)(1). See id. The court rejected Drasner's conclusion
that Section 29(b) renders void only those contracts that
"by their terms" violate the Exchange Act and instead
interpreted Section 29(b) as "render[ing] voidable those
contracts that are either illegal when made or as in fact
performed." Id. at 560. The court concluded that rescission
was proper because, although plaintiffs sought to avoid
contracts that were "perfectly lawful on their face," the
performance of the contracts by Financial nevertheless
"resulted in a violation of the Act." Id. at 561. The court
added: "That these contracts, under different
circumstances, could have been performed without
violating the Act is immaterial." Id.

Although the court of appeals in Regional Properties
rescinded the contracts therein and explicitly rejected
Drasner's narrow reading of Section 29(b), its opinion is
nevertheless consistent with the outcomes in Drasner,
Slomiak, and Zerman. In particular, the violations of the
Exchange Act alleged in Drasner, Slomiak , and Zerman were
"collateral or tangential to the contract between the

                                13
parties," whereas the violation alleged in Regional Properties
was "inseparable from the performance of the contract" that
plaintiffs were attempting to void. Slomiak, 597 F. Supp. at
682. The parties could -- and did -- perform the contracts
at issue in Drasner, Slomiak, and Zerman without
committing any violations of the Exchange Act, but the
broker in Regional Properties could not carry out his
obligations under the agreements without violating the
Exchange Act, for performance of the agreements entailed
selling partnership interests, which the broker lawfully
could not do due to his failure to register as a broker-
dealer.

The other two cases cited by Colkitt are also consistent
with this analysis. In both cases, the courts voided loan
agreements because the banks violated Regulation U, which
governs the amount of money that a bank can lend for the
purchase of registered securities. In Grove v. First National
Bank of Herminie, 489 F.2d 512, 513 (3d Cir. 1974) (per
curiam), bank employees failed to explain to plaintiff that
under federal law, the bank "could lend only a certain
percentage of the market value of stock to purchase
registered securities." Concluding that the bank had
violated Regulation U, we held that Section 29(b) precluded
the bank from recovering a deficiency, "even if the borrower
knowingly and intentionally deceives the bank as to the
actual purposes of the loans." Id. at 516.

In Stonehill v. Security National Bank, 68 F.R.D. 24, 28
(S.D.N.Y. 1975), a bank sought to recover the outstanding
balance on a loan, but the borrower claimed that the loan
was void and unenforceable because the bank issued the
loan in violation of Regulation U. The bank argued that
even if the borrower's obligations were void due to the
bank's alleged violation of Regulation U, it still could
recover from the guarantor. See id. at 33. The court
disagreed, holding that "if the principal obligation violates
Regulation U, a guarantee of that obligation is void under
S 29(b) of the Exchange Act." Id. The court explained that
"allow[ing] a bank to recover on a guarantee even though
the underlying loan violated Regulation U would encourage
banks to extend credit in violation of the margin
requirements." Id. at 34.

                               14
As with the violation of Section 15(a)(1) in Regional
Properties, the violations of Regulation U in Grove and
Stonehill were inseparable from the underlying agreements
between the parties: the banks could not perform their
obligations under the loan agreements (i.e., lend money to
the borrowers so that they could purchase securities)
without violating Regulation U. In fact, the loans were
"made in violation of" the Exchange Act because a greater
percentage of the loans was used to purchase securities
than is allowed under Regulation U.

The same cannot be said for GFL's obligations under the
National Medical and EquiMed notes in this case. GFL's
allegedly unlawful short sales of National Medical and
EquiMed stock were nothing more than "collateral or
tangential" to the notes. Colkitt insists that performance of
the contracts "involves a violation of" securities laws
because "performance itself (exchange of shares and
repayment of the loan plus interest) . . . supports GFL's
illegal short selling by giving GFL shares with which to
cover the short sales." Br. of Appellant at 25 n.8. Despite
the theory of Colkitt's case, however, GFL's short sales are
completely independent of the parties' respective obligations
under the terms of the notes -- namely, GFL's obligation to
lend Colkitt a total of $13,000,000, and Colkitt's obligation
to repay the loans at GFL's option with shares of National
Medical and EquiMed stock. In the end, GFL's alleged
unlawful activity (i.e., its short sales) is too attenuated from
the parties' valid, lawful contracts (i.e., the National Medical
and EquiMed notes) or GFL's performance thereunder.
Therefore, we conclude that the notes were neither made
nor performed in violation of any federal securities laws as
is required for rescission under Section 29(b). 4

B. MARKET MANIPULATION

Colkitt argues that the district court erred in rejecting his
affirmative defense that the notes are void pursuant to
Section 29(b) due to GFL's alleged market manipulation, as
_________________________________________________________________

4. Notwithstanding our conclusions as to the scope of Section 29(b), we
will discuss the market manipulation and securities fraud issues as our
conclusions on them are critical to our disposition of Colkitt's appeal
from the dismissal of his counterclaims. See supra note 3.

                                15
there exist genuine issues of material fact regarding
whether GFL's short sales constituted market manipulation
in violation of Section 10(b) and Rule 10b-5. GFL argues,
however, that Colkitt has not presented enough evidence to
create triable issues on any of the elements of market
manipulation.5
_________________________________________________________________

5. GFL also insists that Colkitt cannot obtain reversal of summary
judgment with respect to GFL's alleged manipulation of National
Medical's price because Colkitt abandoned his market manipulation and
securities fraud claims with respect to National Medical by conceding
that GFL's short sales of National Medical stock did not violate any
securities laws. See Br. of Appellee at 19-21. To support its contention,
GFL quotes a passage from Colkitt's opposition to GFL's motion for
summary judgment, which states that "[t]he short selling of National
Medical presents an interesting contrast to the short selling of EquiMed."
Id. at 20 (quoting Colkitt's Brief in Opposition to Summary Judgment at
6 (App. 000837)). GFL claims that this statement, along with other
unspecified passages in Colkitt's opposition and his motion for
reconsideration, led the district court to limit its rulings to only the
EquiMed note.

GFL's argument is without merit. A review of the district court's April
25, 2000 Memorandum reveals that the court addressed Colkitt's market
manipulation and securities fraud claims as to both EquiMed and
National Medical. Indeed, National Medical is mentioned throughout the
district court's summary judgment and reconsideration rulings. There is
no indication in the district court's rulings that Colkitt abandoned these
claims or that the court limited its rulings to only the EquiMed note.

GFL also distorts the meaning of the above-quoted passage by taking
it out of context. When Colkitt admitted that the short sales of National
Medical differed in some respects to the short sales of EquiMed, he was
referring only to GFL's contention that it engaged in the short sales as
a hedging strategy. As will be explained in more detail below, see infra
pp. 28-30, Colkitt's expert maintains that selling short prior to the
five-
day period before the exchange demand is not a legitimate hedging
strategy, but instead an attempt to profit from declining stock prices.
The expert insists that if GFL were only trying to hedge against a
possible drop in price after the exchange demand (so-called "delivery
risk"), GFL could have eliminated that risk by selling short during the
five-day period before the exchange demand -- in essence, locking in the
sale price during the same period the average closing price would be
calculated. Colkitt's statement was simply an "acknowledgment that,
unlike the EquiMed shorts, the National Medical shorts, by their timing,
could at least qualify as a hedge strategy" because they were made

                                16
1. Elements of Market Manipulation Under Section 10(b)
and Rule 10b-5

As an initial matter, the parties disagree about the specific
elements of market manipulation under Section 10(b) and
Rule 10b-5. To complicate matters further, we seemed not
to have addressed squarely what elements are required to
establish a claim of market manipulation, particularly in
the context of a Section 29(b) affirmative defense, and the
case law from other courts of appeals and district courts on
this issue provides limited guidance. Section 10(b) states in
relevant part that "[i]t shall be unlawful for any person
. . . [t]o use or employ, in connection with the purchase or
sale of any security . . ., any manipulative or deceptive
device or contrivance in contravention of such rules and
regulations" promulgated by the SEC. 15 U.S.C.S 78j. Rule
10b-5 provides in relevant part that "[i]t shall be unlawful
for any person . . . [t]o employ any device, scheme, or
artifice to defraud." 17 C.F.R. S 240.10b-5.

Noting that Section 10(b) outlaws but does not define a
"manipulative or deceptive device or contrivance," Colkitt
turns to Section 9(a) of the Exchange Act to determine the
elements of the offense of market manipulation. Section
9(a) prohibits individuals from effecting "a series of
transactions in any security registered on a national
securities exchange . . . creating actual or apparent active
trading in such security, or raising or depressing the price
of such security, for the purpose of inducing the purchase
or sale of such security by others." 15 U.S.C.S 78i(a)(2).
Based on this passage and the Supreme Court's decision in
Aaron v. SEC, 446 U.S. 680, 695, 100 S.Ct. 1945, 1955
(1980), in which the Court recognized scienter as an
element of a Section 10(b) claim, Colkitt maintains that
summary judgment was improper because he created
genuine issues with respect to each of the following
_________________________________________________________________

within the days immediately preceding GFL's exchange demands for
National Medical stock. Reply Br. of Appellant at 5. This narrow
admission cannot be construed as a complete waiver of his
counterclaims and affirmative defenses with respect to the National
Medical note.

                               17
elements of market manipulation: (1) GFL engaged in a
series of transactions in the registered securities; (2) the
purpose of GFL's short sales was to induce others to sell
the securities; (3) GFL's short sales created "actual or
apparent active trading" in the securities or depressed the
prices of the securities; and (4) GFL acted with scienter.

GFL responds that Colkitt has mischaracterized the
elements of market manipulation by applying an overly
broad description of prohibited activities set forth under
Section 9(a) and by ignoring the specific requirements of
market manipulation that have evolved over time. GFL
points out that market manipulation is "virtually a term of
art when used in connection with the securities market. It
connotes intentional and willful conduct designed to
deceive or defraud investors by controlling or artificially
affecting the price of securities." Ernst & Ernst v.
Hochfelder, 425 U.S. 185, 199, 96 S.Ct. 1375, 1384 (1976).
GFL asserts that Colkitt disregards two necessary elements
of a market manipulation claim -- that "GFL injected
inaccurate information into the marketplace" and that
GFL's conduct "affected the price" of National Medical and
EquiMed stock. Br. of Appellee at 24.

The first disputed element is whether Colkitt must
demonstrate that GFL injected inaccurate information into
the marketplace or created a false impression of market
activity. Like the district court, GFL relies on Olympia
Brewing, 613 F. Supp. at 1292, in which the district court
emphasized that the "essential element" of a market
manipulation claim is the injection of "inaccurate
information" into the market. GFL observes that even the
cases cited by Colkitt "recognize that market manipulation
requires an additional element, something beyond
otherwise legal trading, which specifically injects false
information into the market and/or creates an artificial
demand for the underlying security." Br. of Appellee at 22
(emphasis added). Colkitt responds, however, that he is not
required to present evidence that "GFL injected affirmative
misinformation into the market," but only needs to
demonstrate that "GFL's short trades were made for the
undisclosed purpose of artificially depressing share prices."
Reply Br. of Appellant at 9 (emphasis added).

                               18
Notwithstanding Colkitt's assertion to the contrary, the
parties appear to be in accord on this point. Indeed, the
difference between their positions seems to be one without
distinction. Both GFL and Colkitt focus on the need to
demonstrate that some action was taken to artificially
depress or inflate prices, whether by purposely making
false statements or by employing illegitimate, deceptive
trading techniques that mislead investors about the price or
demand for a stock.

To the extent that the parties' respective positions are at
odds, however, GFL advances a sounder construction of a
Section 10(b) market manipulation claim, for it is less
vague than Colkitt's. The Supreme Court has indicated that
market manipulation "generally refers to practices, such as
wash sales, matched orders, or rigged prices, that are
intended to mislead investors by artificially affecting market
activity." Santa Fe Indus. v. Green, 430 U.S. 462, 476, 97
S.Ct. 1292, 1302 (1977). "The gravamen of manipulation is
deception of investors into believing that prices at which
they purchase and sell securities are determined by the
natural interplay of supply and demand, not rigged by
manipulators." Gurary v. Winehouse, 190 F.3d 37, 45 (2d
Cir. 1999). In that vein, courts must distinguish between
legitimate trading strategies intended to anticipate and
respond to prevailing market forces and those designed to
manipulate prices and deceive purchasers and sellers.
Although Colkitt's construction properly reflects the
aspiration of Section 10(b) of preventing market activities
that artificially depress prices, it provides little guidance on
which activities artificially affect prices and which activities
legitimately impact prices.

Requiring a Section 10(b) plaintiff to establish that the
alleged manipulator injected "inaccurate information" into
the market or created a false impression of market activity
cures this problem. Such a construction permits courts to
differentiate between legitimate trading activities that
permissibly may influence prices, such as short sales, and
"ingenious devices that might be used to manipulate
securities prices," Santa Fe Indus., 462 U.S. at 477, 97 S.
Ct. at 1303, such as wash sales and matched orders. As
the court in Olympia Brewing, 613 F. Supp. at 1292,

                               19
stated, "[r]egardless of whether market manipulation is
achieved through deceptive trading activities or deceptive
statements as to the issuing corporation's value, it is clear
that the essential element of the claim is that inaccurate
information is being injected into the marketplace."

The second disputed element is whether Colkitt must
establish that GFL's allegedly manipulative conduct
actually depressed the prices of National Medical and
EquiMed stock. GFL argues that market manipulation in
violation of Section 10(b) and Rule 10b-5 requires that the
allegedly unlawful conduct impact a security's price. GFL
cites three cases to support its position, but all three are
unhelpful. First, although we stated in Rosenberg v. Hano,
121 F.2d 818, 821 (3d Cir. 1941) (footnote omitted), that
"the party claiming injury must plead and prove some
change in price, because of the prohibited acts," the case
involved an alleged violation of Section 9, not Section 10(b)
and Rule 10b-5. Second, the opinion in United States v.
Russo, 74 F.3d 1383, 1394 (2d Cir. 1996), is not significant
here because it only addressed the propriety of the portion
of the district court's jury instruction on the scienter
element that defined artificial price as the price level above
the stock's actual value as determined by market forces.
Third, the decision in In re Blech Securities Litigation, 928
F. Supp. 1279, 1298 (S.D.N.Y. 1996) (citation omitted),
directly contradicts GFL's position by stating that"[t]he
absence of allegations of market dominance and price
movement are not fatal to" a claim of market manipulation,
for although "these may be classic attributes of market
manipulation, they are not requisites."

Colkitt's position is somewhat inconsistent on this point.
On the one hand, he takes great pains to argue that GFL's
short sales depressed the price of National Medical by
17.5% and the price of EquiMed by 18.5%. On the other
hand, when confronted with evidence that the prices of the
stocks were on a sharp downward trend before and after
GFL's short sales, thus raising serious doubts about the
true reason for the declining prices, Colkitt reverses course
and argues that he need not prove that GFL's alleged
scheme was successful in depressing prices. Colkitt insists
that he only must establish that GFL attempted to depress

                               20
prices by selling shares short. To muddy the waters even
more, Colkitt appears to make a concession that an impact
on price must be established when he states in his reply
brief: "A jury must also decide whether GFL's short trades
had an affect [sic] on share prices." Reply Br. of Appellant
at 11.

Despite his flip-flopping on the issue, Colkitt appears to
be correct that he need not prove that GFL's manipulative
conduct actually depressed prices. The Court of Appeals for
the Fifth Circuit concluded in Chemetron Corp. v. Business
Funds, Inc., 718 F.2d 725, 728 (5th Cir. 1983), that Section
10(b), unlike Section 9(a), does not require that a plaintiff
prove the allegedly unlawful activities had an effect on the
price of the stock. Although any damages that Colkitt
would be entitled to recover under his Section 10(b) and
Rule 10b-5 counterclaim would be contingent on proving
that GFL's conduct actually depressed prices, proof of price
movement is not necessary to establish a violation of
Section 10(b) and Rule 10b-5 and therefore is not necessary
to support his assertion of an affirmative defense under
Section 29(b).6
_________________________________________________________________

6. Although maintaining a private right of action under Section 10(b)
requires a plaintiff to prove reliance and damages (usually reflected in
the stock's price movement), Section 29(b) only requires a violation of
Section 10(b), not the maintenance of a private suit under Section 10(b).
Therefore, looking to the statutory language of the anti-fraud provision,
we note that an individual violates Section 10(b)-- and therefore triggers
Section 29(b) -- when he or she employs manipulative or deceptive
devices in connection with the purchase or sale of securities. This
situation is analogous to a government prosecution under Section 10(b),
in which the government is not required to meet the normal standing
requirements imposed on those asserting a private remedy, inasmuch as
the government need not demonstrate that the defendant's conduct
induced reliance by investors or affected the price of the security. See,
e.g., United States v. Haddy, 134 F.3d 542, 549 (3d Cir. 1998) (holding
that reliance is not an element of the crime of stock manipulation).

Even if we were to embrace the position of GFL and the district court
that proof of an effect on price is necessary to establish a claim of
market manipulation, the district court still erred in concluding that
Colkitt failed to create a genuine issue of material fact with respect to
price movement. As already noted, Colkitt claims that the price of

                               21
We are satisfied that, at bottom, neither party properly
articulates the elements of market manipulation under
Section 10(b) in the context of a Section 29(b) affirmative
defense. Because we have not squarely addressed this
issue, we must set forth the necessary elements for such a
claim. In this regard, we conclude that to establish a
Section 29(b) affirmative defense of market manipulation in
violation of Section 10(b) and Rule 10b-5, Colkitt must
present evidence that (1) in connection with the purchase
or sale of securities, (2) GFL engaged in deceptive or
manipulative conduct by injecting inaccurate information
into the marketplace or creating a false impression of
supply and demand for the security (3) for the purpose of
artificially depressing or inflating the price of the security.

2. Evidence Supporting Colkitt's Claim of Market
Manipulation

Colkitt's affirmative defense based upon GFL's alleged
market manipulation fails because he cannot demonstrate
_________________________________________________________________

National Medical dropped 17.5% and the price of EquiMed plummeted
18.5% during the period of GFL's short sales. The district court
concluded, however, that these statistics are "not evidence that the value
of the shares was affected by the short sales: the free fall began before
the short sales and continued well after the short sales." GFL Advantage
Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and Order at 21
(M.D. Pa. July 17, 2000). The district court observed that the price of
EquiMed declined steadily from $15.00 on February 1, 1996, to $2.4583
on January 2, 1998, including a dramatic drop of 27.6%, from $7.25 to
$5.25, during the 24-day period immediately preceding GFL's short
sales. See id. at 20-21. The court also noted that National Medical
plummeted from $12.875 on May 1, 1996, to $0.4375 on January 2,
1998. See GFL Advantage, Ltd. v. Colkitt, No. 4:CV-97-0526,
Memorandum and Order at 18 (M.D. Pa. Apr. 25, 2000). Based on these
long-term, downward trends in the stocks' prices, the district court
concluded that Colkitt could not prove that GFL's short sales had an
effect on the price of either National Medical or EquiMed stock. Although
the court was correct that other factors clearly were contributing to the
slide in prices, it was not within the court's province to weigh the
evidence as a finder of fact. Whether and how much GFL's alleged
unlawful conduct contributed to the downturn in prices would have been
issues for the jury if Colkitt's case had survived GFL's motion for
summary judgment. Contrary to the district court's conclusion, Colkitt
clearly created genuine issues as to whether GFL's short sales affected
the prices of National Medical and EquiMed.

                               22
that GFL engaged in any deceptive or manipulative conduct
by injecting false inaccurate information into the
marketplace or creating a false impression of supply and
demand for the stock. As the district court explained
repeatedly in its two rulings, Colkitt has not presented any
evidence that GFL did anything but lawfully engage in short
sales of National Medical and EquiMed stock. The fact that
these short sales may have contributed to a decline in the
stocks' prices is not evidence of deceptive or manipulative
conduct, for there is no reason to believe these prices were
depressed artificially. See Sullivan & Long, Inc. v. Scattered
Corp., 47 F.3d 857, 864 (7th Cir. 1995) (concluding that
defendant's "unprecedented massive short selling" did not
create "a false impression of supply and demand" because
on the other side of defendant's transactions were"real
buyers, betting against [defendant], however foolishly, that
the price of [the] stock would rise"); Olympia Brewing, 613
F. Supp. at 1296 (stating that "short selling is simply not
unlawful, even in large numbers and even if the trading
does negatively affect the purchase price"). Indeed, the
district court stated it well when it wrote that it is
unreasonable "to infer unlawful intent from lawful activity
alone." GFL Advantage Fund, Ltd. v. Colkitt , No. 4:CV-97-
0526, Memorandum and Order at 19 (M.D. Pa. July 17,
2000).

In the cases Colkitt cites in which courts concluded that
a party's short selling was part of a scheme to manipulate
stock prices, the short selling was in conjunction with some
other deceptive practice that either injected inaccurate
information into the market or otherwise artificially affected
the price of the stock. See Russo, 74 F.3d at 1387, 1390,
1391 (defendants used short sales in concert with
"unauthorized placements" and "parking" of stock in
customers' accounts to generate false credits that funded
their "stock-kiting scheme" designed to artificially inflate
stock prices); United States v. Regan, 937 F.2d 823, 829 (2d
Cir. 1991) (defendants sought to depress temporarily the
price of stock by arranging to have 40,000 shares sold
short secretly to a broker-dealer without disclosing to the
dealer the identity of the seller or the moving party behind
the deal); United States v. Charnay, 537 F.2d 341, 344 (9th
Cir. 1976) (to facilitate a take-over bid, defendants

                               23
artificially depressed stock prices by getting others to sell
86,100 shares short and "guaranteeing these sellers by
secret understanding a recovery of $22 per share
irrespective of the price obtained on the Exchange");
Advanced Magnetics, Inc. v. Bayfront Partners, Inc. , No. 92
Civ. 6879 (CSH), 1996 WL 14440 (S.D.N.Y. Jan. 16, 1996)
(defendant attempted to depress stock prices through short
sales that contravened Section 10(a) of the Exchange Act
and Rule 10a-1 thereunder, which prohibits a short sale
"below the price at which the last sale" of the security was
reported), vacated in part on other grounds, 106 F.3d 11 (2d
Cir. 1997).

The remaining cases of market manipulation Colkitt cites
likewise involved either injection of inaccurate information
into the market or creation of a false impression of supply
and demand for a stock. See Santa Fe Indus., 430 U.S. at
467, 97 S.Ct. at 1298 (defendant obtained "fraudulent
appraisal" of stock that severely undervalued its worth "in
order to lull the minority stockholders into erroneously
believing that [its cash-exchange offer] was generous");
Crane Co. v. Westinghouse Air Brake Co., 419 F.2d 787,
792-93 (2d Cir. 1969) (in an effort to inflate prices and
thwart a corporate take-over, defendant "painted the tape"
by purchasing large blocks of stock in the open market at
inflated prices while simultaneously making large secret
and unreported sales at lower prices to partially finance the
purchases); Blech, 928 F. Supp. at 1286, 1298 (defendant
arranged "sham transactions" to inflate prices by
improperly directing trades into and out of brokerage
accounts at the firm without the authorization of the
owners of the accounts); SEC v. Kimmes, 799 F. Supp. 852,
856-57 (N.D. Ill. 1992) (defendant maintained artificially
high stock prices by buying and selling stock through
"undisclosed nominee accounts," distributing"false and
misleading registration statements," and filing"false and
materially misleading period reports" with the SEC), aff'd
sub nom., SEC v. Quinn, 997 F.2d 287 (7th Cir. 1993); SEC
v. Malenfant, 784 F. Supp. 141, 144-45 (S.D.N.Y. 1992)
(defendant arranged "matched buy and sell orders" to
"create a misleading appearance of active trading in the
Texscan common stock" and thus drive up the price of the

                               24
stock). Once again, Colkitt fails to proffer any evidence that
GFL engaged in any such inappropriate conduct.

Colkitt attempts to overcome this dearth of evidence of
deceptive or manipulative conduct on the part of GFL by
claiming that short sales, by their very nature,"convey to
market participants negative information about the
prospects of the firm." Br. of Appellant at 39. Colkitt's
argument misses the mark, however, because conveying
negative information about a firm does not constitute
market manipulation unless the information is untruthful.
Indeed, legitimate short sales often convey negative
information about a company insofar as short sales suggest
that a stock's price is overvalued, but that does not mean
that such sales distort the market. To the contrary, short
selling can help move an overvalued stock's market price
toward its true value, thus creating a more efficient
marketplace in which stock prices reflect all available
relevant information about the stock's economic value. See
Sullivan & Long, 47 F.3d at 861-62.

Colkitt maintains that National Medical and EquiMed
were not overvalued. He insists that, because GFL did not
argue before the district court that it sold short because it
believed the stocks were overvalued, Colkitt is entitled to
the inference that "the short sales were made at least in
part to convey to the market the false impression that the
stocks were overvalued so as to result in a decline in share
prices." Br. of Appellant at 40 (emphasis in original). It
would not be reasonable to draw such an inference,
however, for to do so would fly in the face of uncontradicted
evidence that the prices of National Medical and EquiMed
were on a dramatic slide before and after GFL's short sales.
If we were to draw any inference from the record evidence
about the value of National Medical and EquiMed, it would
be that the market considered the stocks to be overvalued
and that GFL simply was responding to market forces,
rather than distorting them, by engaging in short sales.

An examination of Colkitt's other requested inferences,7
_________________________________________________________________

7. The parties disagree about the standard of review that should be
applied to Colkitt's requested inferences. GFL contends that the standard

                                25
see Br. of Appellant at 30-35, exposes Colkitt's claims for
what they are -- nothing more than a general attack on the
lawful practice of short selling. For instance, Colkitt's first
two inferences -- that GFL had a "unique financial
incentive" to depress the prices of National Medical and
EquiMed because its profits increased as the market prices
decreased,8 and that short selling "conveys negative
information" about the company being short sold and
contributes to a drop in share prices -- are general
criticisms of short selling. These inferences, even if granted,
are of no help to Colkitt in trying to prove market
manipulation, inasmuch as short selling is a lawful
investment strategy. Colkitt's next three requested
inferences -- that GFL's short sales constituted a large
percentage of shares sold on a daily basis, that GFL's short
_________________________________________________________________

is abuse of discretion because Colkitt raised these inferences for the
first
time when it filed its motion for reconsideration. Colkitt maintains that
the standard is plenary because he raised all of the evidence and
advanced all of the arguments at earlier stages in the litigation. This
point is moot, however, because we would uphold the district court's
rulings with respect to the inferences under either standard.

8. Colkitt believes that GFL's incentive to depress prices is "unique"
because the structure of the convertible notes allows GFL to receive more
shares -- and thus higher profits -- as the stocks' prices decline. This
incentive, however, is not unique to GFL's situation. All short sellers
receive higher profits as the stock's price declines. Indeed, these higher
profits in the face of declining prices are why traders engage in short
sales. They are betting that the stock's price will decline, and if it
does
so, they will have to spend less money buying replacement stock to cover
the borrowed shares, thus allowing them to pocket the difference.

Colkitt's differentiation between GFL and other short sellers based on
the structure of the National Medical and EquiMed notes is misguided.
Whether GFL acquires $100,000 worth of shares from Colkitt in
exchange for debt (as GFL did here) or in exchange for cash (as short
sellers normally do when they cover) is irrelevant. In either situation,
GFL will be able to obtain more shares from Colkitt if prices decline.
Thus, if this "unique" incentive to depress prices is evidence that GFL
engaged in market manipulation, then all short traders are likewise
guilty of manipulating markets in violation of Section 10(b). Of course,
this position is untenable, for as already explained, short selling is
perfectly lawful.

                               26
sales caused a 17.5% decline in National Medical and an
18.5% decline in EquiMed,9 and that these price slumps
allowed GFL to obtain an additional 11,658 shares of
National Medical and an additional 27,882 shares of
EquiMed from Colkitt -- are equally unavailing. Once again,
short selling, even in large volumes, is not in and of itself
unlawful and therefore cannot be regarded as evidence of
market manipulation. That short selling may depress share
prices, which in turn may enable traders to acquire more
shares for less cash (or in this case, for less debt), is not
evidence of unlawful market manipulation, for they simply
are natural consequences of a lawful and carefully
regulated trading practice.10

Colkitt's remaining inferences are equally groundless.
Because a court is required to indulge only reasonable
inferences, we reject Colkitt's last three requested
inferences. For instance, Colkitt insists that GFL's use of
four different brokers to execute the short trades is
evidence that GFL tried to conceal its short sales from
market participants, including Colkitt. This inference is
unreasonable as GFL needed to use four brokers because
none of them had enough shares necessary for GFL to
_________________________________________________________________

9. As already noted, see supra note 1, Colkitt greatly exaggerates
EquiMed's price decline. The price of EquiMed on the day of the GFL's
first short sale on November 8, 1996, was $5.25 per share, and its price
on the day of GFL's last short sale on November 22, 1996, was $5.13.
Consequently, the price of EquiMed dipped only $.12, or 2.3%.

10. A passage in Colkitt's reply brief further undermines his theory that
short sales are manipulative because they depress prices. He writes: "It
is reasonable and makes economic sense to infer that short selling drives
down share prices, because each short sale is, itself, a `sale,'
increasing
supply . . . ." Reply Br. of Appellant at 15 (emphasis added). In other
words, Colkitt believes that short sales are manipulative because they
increase the stock's supply and drive down its price. This, of course, is
true (assuming demand remains constant), but it is also true for all
stock sales, whether they are from long positions or short positions. The
rationale of Colkitt's theory would lead to the absurd result of outlawing
any sales practice that increases a security's supply and consequently
may affect its price. Colkitt fails to understand that increasing the
supply of stocks by selling them on the open market in legitimate
transactions to real buyers does not artificially affect prices and
therefore
cannot be manipulative.

                               27
borrow to carry out all of its short sales, which is not
unusual when dealing with small cap stocks. See Br. of
Appellee at 39 (citing Cason Aff. P 13 (App. 001080)).

Colkitt's next requested inference relates to GFL's
assertion that it sold National Medical and EquiMed short
to hedge against the stocks' declining prices and to lock in
the notes' 17.5% and 18.5% profit spreads. Colkitt offers
expert testimony that GFL's short sales could not have been
part of a legitimate hedging strategy because too much time
elapsed between the short sales and the exchange
demands. The expert avers that if GFL were only trying to
protect itself against declining prices after it made its
exchange demand, it could have eliminated that "delivery
risk" by selling short during the five-day period before the
exchange demand, thus locking in the sale price during the
same period the average closing price would be determined.
Because GFL waited so long after the short sales to make
its exchange demands, the expert contends GFL was not
simply hedging against slumping prices, but was
"increas[ing] the likelihood of increasing profits through
artificially (and temporarily) lowering the price of EquiMed."11
Br. of Appellant at 16-17 (quoting Expert Report of
Professor Steven R. Grenadier P 20. (App. 000860-000861)).

Accepting as true Grenadier's position that GFL could
have hedged against all risk by selling short during the five-
days prior to the exchange demands, a court reasonably
could infer that GFL not only sought to protect itself, but
also endeavored to reap further profit from the stocks'
declining prices by selling short. To infer that these
"premature" short sales were executed to manipulate
prices, however, would be an unreasonable leap. Indeed,
Grenadier admits in his deposition that he does not have
an opinion about whether GFL's short sales artificially
depressed the prices of EquiMed stock. See Grenadier Dep.
at 37 (App. 001016). Therefore, although it may be
reasonable to infer from Grenadier's report that GFL's short
_________________________________________________________________

11. Grenadier mentions only EquiMed because GFL sold National
Medical short during the five-day period prior to its exchange demands
to the stock. Therefore, even under Grenadier's theory, GFL's short
trades of National Medical qualify as a legitimate hedging strategy.

                               28
sales were intended not only to hedge against declining
prices but to profit from them, it would be unreasonable to
infer that GFL's short sales were deceptive or manipulative,
especially considering that the expert concedes that he does
know whether the trades had the effect of manipulating the
prices.12

Finally, in the words of the district court, Colkitt's last
requested inference amounts to "baseless and desperate
mudslinging." Colkitt asserts that GFL was sued twice "for
engaging in manipulative short selling" thus evidencing that
it engaged in that type of conduct with regard National
Medical and EquiMed stock. Br. of Appellant at 35. GFL
responds that it was not even involved in Global Intellicom,
Inc. v. Thomson Kernaghan & Co., No. 99-CIV-342, 1999
WL 544708 (S.D.N.Y. July 27, 1999). Instead, the case
involved a former employee whose allegedly unlawful
conduct occurred after he left GFL. GFL also asserts that
the action in JTS Corp. v. GFL Advantage Fund, Ltd. was
dismissed in the early stages of the litigation after it filed
for Rule 11 sanctions against the plaintiff. Based on GFL's
averments, it would be entirely inappropriate to grant
Colkitt's requested inference that these two lawsuits are
evidence of GFL's alleged market manipulation in this case.

At bottom, the core of Colkitt's argument is premised on
his belief that short selling artificially depresses prices and
presumably should be banned as a market manipulation.
Unfortunately for Colkitt, however, short selling is lawful,
and courts have held that short selling, even in massive
volume, is neither deceptive nor manipulative when carried
out in accordance with SEC rules and regulations. See
_________________________________________________________________

12. Other portions of Grenadier's report also appear to undermine such
a conclusion. In particular, Grenadier endorses the conclusions of
Harvard Business School's Paul Asquith and Lisa Meulbroek that short
trading would have an impact on the value of the securities if the
number of shares sold short constituted 2.5% or more of the total
outstanding shares. See Grenadier Dep. at 80-81 (App. 001017-001018).
In this case, GFL sold short a total of 78,700 shares of EquiMed, which
constituted only .275% of EquiMed's 28,589,717 outstanding shares.
Therefore, under the standard embraced by Colkitt's own expert, GFL's
short sales of EquiMed stock would not be expected to have a noticeable
impact on the stock's price.

                               29
Sullivan & Long, 47 F.3d at 864-65. Therefore, to make out
a claim of market manipulation, Colkitt must present
evidence that GFL engaged in some other type of deceptive
behavior in conjunction with its short selling that either
injected inaccurate information into the marketplace or
created artificial demand for the securities. Colkitt has
offered nothing but evidence that GFL engaged in lawful
short sales of National Medical and EquiMed, which alone
is insufficient to prevail on a claim of market manipulation
in violation of Section 10(b) and Rule 10b-5.

Another reason why Colkitt's market manipulation claim
fails is because he has not met the scienter requirement by
offering evidence that GFL engaged in short sales for the
purpose of artificially depressing the prices of National
Medical and EquiMed stock. Citing our opinion in In re
Advanta Corp. Securities Litigation, 180 F.3d 525, 535 (3d
Cir. 1999), Colkitt argues that he has met the recklessness
standard for liability under Section 10(b). He contends that
GFL's conduct constitutes "an extreme departure from the
standards of ordinary care" and "presents a danger of
misleading buyers and sellers that is either known to the
defendant or is so obvious that the actor must have been
aware of it." Id. (internal quotation marks omitted).
According to Colkitt, evidence of GFL's alleged recklessness
includes: GFL's "powerful economic incentive" to depress
the stocks' prices; "voluminous scholarly evidence" that
GFL's short sales would convey a "negative impression" of
the companies; the dramatic drop in the stocks' prices
during the period of GFL's short selling; the additional
39,540 shares that GFL "extracted" from Colkitt because of
the declining prices; GFL's use of four brokers to conceal
his short sales; the conclusion of Colkitt's expert that GFL's
short sales were not part of a legitimate hedging strategy;
and GFL's having been sued twice for similar conduct.

In essence, Colkitt recycles his arguments that he
advanced in support of his contention that GFL's short
trades were manipulative and deceptive. Some of this
evidence and the requested inferences to be taken
therefrom already have been discredited -- GFL's use of
multiple brokers, whether GFL's short sales were a
legitimate hedge strategy, and the alleged lawsuits against

                               30
GFL for engaging in short selling -- and the rest of the
evidence and inferences are, once again, general attacks on
the practice of selling short -- the powerful incentive to
depress prices, the negative impression of the company
conveyed by short sales, the actual drop in National
Medical and EquiMed prices, and the additional shares GFL
obtained because of the declining prices. All that this
information proves is that GFL engaged in the lawful
practice of selling stock short and that these short sales
may or may not have affected the price of National Medical
and EquiMed stock. This evidence neither establishes that
GFL's short sales were manipulative nor demonstrates that
GFL executed the trades for the purpose of depressing the
stocks' prices. Perhaps, if Colkitt had offered evidence that
GFL's short sales violated SEC rules (for instance, if GFL
failed to cover properly the short sales in violation of Rule
10a-2, or if GFL made short sales below the last sales price
in violation of Rule 10a-1), Colkitt might have been able to
establish that GFL's conduct was intentionally or recklessly
manipulative or deceptive. In the absence of evidence that
GFL engaged in any wrongful conduct, however, Colkitt's
claim of market manipulation must fail. Therefore, we will
affirm summary judgment in favor of GFL with respect to
the market manipulation claim.

C. SECURITIES FRAUD

Colkitt also claims that the notes should be voided
pursuant to Section 29(b) on the grounds that GFL
committed securities fraud in violation of Section 10(b) and
Rule 10b-5 when it failed to disclose its intent to
manipulate the prices of National Medical and EquiMed
stock through short sales. GFL responds that it had no
duty to disclose its intent to engage in short sales and that
Colkitt has not established that he either relied on this
alleged omission of fact or suffered a cognizable injury as a
result of the reliance.

1. Elements of Securities Fraud Under Section 10(b) and
Rule 10b-5

It is well settled that a claim of securities fraud under
Section 10(b) requires proof "that the defendant (1) made
misstatements or omissions of material fact; (2) with

                               31
scienter; (3) in connection with the purchase or sale of
securities; (4) upon which plaintiffs relied; and (5) that
plaintiffs' reliance was the proximate cause of their injury."
Weiner v. Quaker Oats Co., 129 F.3d 310, 315 (3d Cir.
1997) (citation and internal quotations omitted). The parties
apparently agree that the third element has been
established, as there is no dispute that the alleged fraud
was related to the purchase or sale of National Medical and
EquiMed securities. Therefore, Colkitt must establish
genuine issues with respect to the following elements:
omissions of material fact, reliance, cognizable injury, and
scienter.13

2. Evidence Supporting Colkitt's Claim of Securities
Fraud

Colkitt asserts that GFL concealed from him two critical
pieces of information that constitute omissions of material
fact: (1) GFL's intention to sell short National Medical and
EquiMed stock; and (2) GFL's actual short sales of the
stock. Colkitt maintains that GFL had an affirmative duty
to disclose this information because it was material and he
would not have entered into the contracts with GFL if he
had known it planned to sell the stocks short.

Analysis of a securities fraud claim under Section 10(b)
and Rule 10b-5 includes two steps: "First, was the
defendant under a duty to disclose at the time at issue?
Second, was the alleged omission or misstatement
material? If, under the facts of this case, no duty to disclose
exists, or if the undisclosed facts are not material, there is
no liability under Rule 10b-5." Staffin v. Greenberg, 672
F.2d 1196, 1202 (3d Cir. 1982). A duty to disclose arises
only when one party to a transaction has material
information that the other party is entitled to have because
of some relationship of trust and confidence between the
parties, such as when one party is a fiduciary, corporate
insider, or "tippee." See Chiarella v. United States, 445 U.S.
222, 229, 100 S.Ct. 1108, 1115 (1980). The Supreme Court
has determined that "[a]n omission of fact is material if
_________________________________________________________________

13. Colkitt submits the same evidence of scienter in support of both his
securities fraud claim and his market manipulation claim. See supra pp.
30-31.

                               32
there is a substantial likelihood that a reasonable
shareholder would consider it important in deciding"
whether to invest. Basic, Inc. v. Levinson, 485 U.S. 224,
231, 108 S.Ct. 978, 983 (1988) (quoting TSC Indus., Inc. v.
Northway, Inc., 426 U.S. 438, 449, 96 S.Ct. 2126, 2132
(1976)). Materiality is a mixed question of law and fact and
should be decided as a matter of law "[o]nly when the
disclosures or omissions are so clearly unimportant that
reasonable minds could not differ." In re Craftmatic Sec.
Litig., 890 F.2d 628, 641 (3d Cir. 1990).

Colkitt's securities fraud claim falters for at least one and
possibly two reasons. To start with, he failed to present any
evidence that GFL intended to engage in short sales at the
time it loaned the money to Colkitt. See In re Phillips
Petroleum Secs. Litig., 881 F.2d 1236, 1245 (3d Cir. 1989)
(stating that "a statement of intent need only be true when
made; a subsequent change of intention will not, by itself,
give rise to a cause of action under Section 10(b) or Rule
10b-5"). More significantly, even if we can draw an
inference that GFL had such a plan, it did not have a duty
to disclose its intentions.

Colkitt argues that GFL had a duty to disclose its
intentions because such a disclosure was necessary to
clarify GFL's "implicit" representations that the debt-for-
stock exchange price would be "based upon the accurate,
unbiased and untainted market price quoted by the stock
market." Br. of Appellant at 48. Colkitt explains that
Section 10(b) and Rule 10b-5 impose a "duty to disclose
any material facts that are necessary to make disclosed
material statements, whether mandatory or volunteered,
not misleading." Craftmatic, 890 F.2d at 641. He asserts
that GFL's implicit guarantee that the exchange price would
be based upon prevailing market forces "was rendered
grossly misleading by GFL's failure to disclose that it
intended to short sell EquiMed and National Medical." Br.
of Appellant at 48-49.

We must reject Colkitt's argument for it is premised on
the misguided notion that short sales distort markets and
thus produce inaccurate, biased, and tainted market prices.
As already explained, short sales executed in accordance
with SEC rules and regulations not only are lawful, but also

                               33
do not distort markets or create a false impression of
supply and demand because they are legitimate
transactions with real buyers on the other side of the sale
who are betting that the stock's price will rise. See Sullivan
& Long, 47 F.3d at 864. Contrary to Colkitt's assertion,
GFL's short sales did not render its guarantee misleading,
and GFL consequently did not have a duty to disclose to
Colkitt its intention to engage in short selling. Therefore,
because Colkitt failed to create a genuine issue with respect
to GFL making an omission of material fact, we will affirm
summary judgment in favor of GFL with respect to the
securities fraud claim.

D. REINSTATEMENT OF FEDERAL SECURITIES LAW
COUNTERCLAIMS

Colkitt argues that the district court erred when it
dismissed his amended counterclaims for lack of specificity
on February 2, 1999. He simply states that he pled his
amended counterclaims, which span 30 pages, with
sufficient specificity pursuant to Fed. R. Civ. P. 9. We need
not consider these contentions, however, because, as we
have explained, Colkitt failed to create genuine issues of
material fact as to certain elements of his corresponding
affirmative defenses, and thus, his counterclaims must fail
on the merits as well.

E. VIOLATIONS OF PENNSYLVANIA LAWS

1. Securities Claims

Section 1-508 of the Pennsylvania Securities Act bars the
basing of certain suits on contracts that violate state
securities laws. See Pa. Stat. Ann. tit. 70,S 1-508 (1994).
Section 1-401 of the Pennsylvania Securities Act prohibits
the use of any "device, scheme or artifice to defraud" and
the omission of any "material fact necessary in order to
make statements made, in light of the circumstances under
which they were made, not misleading." Id. S 1-401(a), (b).
Finally, Pennsylvania common law permits "[t]he recipient
of a misrepresentation [to] avoid the contract by showing
that the misrepresentation was either fraudulent or
material." Germantown Mfg. Co. v. Rawlinson , 491 A.2d
138, 141 (Pa. Super. Ct. 1985). As GFL asserts, these
provisions are "functionally identical" to Section 29(b) and

                               34
Section 10(b) of the Exchange Act. See Rosen v.
Communication Serv. Group, Inc., 155 F. Supp. 2d 310, 321
n.14 (E.D. Pa. 2001) ("Section 401 of the Pennsylvania
Securities Act is modeled after Rule 10b-5 of the federal
securities laws, and requires virtually the same elements of
proof."). Therefore, Colkitt's state securities and common
law fraud claims fail for the same reasons his federal
securities claims fail.

2. Breach of Contract Claim

Colkitt argues that GFL is barred under Pennsylvania law
from enforcing the notes because GFL committed a material
breach of the contracts by refusing to accept Colkitt's
prepayment, even though the notes contain no language
prohibiting prepayment. Colkitt claims that he notified GFL
in late December 1996 and early January 1997 that he
would prepay all outstanding principal and interest on the
notes, but GFL improperly rejected Colkitt's request for
prepayment in hopes of declaring the notes in default and
collecting millions of dollars in penalties.

GFL responds that it did not outright reject Colkitt's
request for prepayment, but conditionally accepted the
prepayment offer while reserving its rights to dispute the
balance due. GFL not only disagreed with Colkitt about the
amounts due, but refused to allow Colkitt to dictate the
terms of any prepayment. Because of its conditional
acceptance of Colkitt's offer, GFL maintains that whether or
not the notes permitted prepayment is not at issue. 14 GFL
also argues that Colkitt's failure to tender any prepayments
-- or any payments, for that matter -- undermines his
position that he was attempting to make a full prepayment
of outstanding principal and interest.
_________________________________________________________________

14. The district court, responding to Colkitt's assertion that the notes
do
not permit GFL either to reject or accept conditionally an offer of
prepayment, stated that "nothing in the agreements requires GFL to
accept prepayment in an amount unilaterally imposed by Colkitt." GFL
Advantage Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and
Order at 24 (M.D. Pa. Apr. 25, 2000). Thus, the court concluded that
"GFL's acceptance while reserving its rights to the disputed amount does
not constitute a breach of contract." Id.

                               35
More importantly, however, Colkitt admitted that he was
in material breach of his obligations on the notes before his
first prepayment offer. In particular, he was in default on
his interest obligations, he failed to maintain a pledge of
securities in escrow, and he neglected to file required
disclosure documents with the SEC. See Colkitt Dep. at
272-73, 261-62, 195-97 (App. 000581-000582, 000577-
000578, 000552-000554). In light of these prior breaches,
the district court did not err in granting summary judgment
in favor of GFL on its breach of contract claim.

F. DAMAGES

The district court granted GFL damages in the amount of
$21,121,989.39. Colkitt argues that the damages should be
limited to principal and interest outstanding as of the date
of his prepayment request, which would reduce the
damages to $11,740,198.

First, Colkitt believes that GFL forfeited its right to collect
anything but principal and interest when it rejected
Colkitt's prepayment offer. As already addressed, he
maintains that GFL's refusal to accept prepayment
constituted a breach of contract and that if GFL had
accepted his prepayment offer as it allegedly was obligated
to do, he would have owed only $11,740,198. Colkitt
cannot prevail on this argument, however, as he never
actually tendered the $11,740,198 prepayment. Depriving
GFL of the interest and penalties due on a balance that
Colkitt never paid would reward him unfairly for his breach
by allowing him to hold onto GFL's money interest free for
nearly four and a half years.

Second, Colkitt argues that GFL is prohibited from
recovering both the 20.5%/22% "premium" and the 14%
"default interest" because they constitute an unenforceable
penalty "that is disproportionate to the value of the
performance promised or the injury that has actually
occurred." Br. of Appellant at 64 (quoting Finkle v. Gulf &
Western Mfg. Co., 744 F.2d 1015, 1021 (3d Cir. 1984)).
Colkitt claims that the "premiums" exceed the profit GFL
would have been able to earn had it exchanged all of the
debt for shares of National Medical and EquiMed and sold
the shares on the market. He also insists that adding 14%

                               36
"default interest" to the premiums is simply punitive and
constitutes unenforceable liquidated damages.

We reject Colkitt's request to reduce the damage award.
Both the "premiums" and the "default interest" compensate
GFL for distinct economic losses suffered by GFL as a
result of Colkitt's breach. The 20.5% and 22% "premiums"
represent the grossed-up value of the 17% and 18%
discounts guaranteed in the notes. The premiums are
intended to restore GFL to the position where it would have
been if GFL had been able to convert all of the debt into
National Medical and EquiMed stock. In contrast, the
"default interest" is intended to compensate GFL for
damages it incurred since Colkitt's breach -- namely, the
deprivation of its money over the past four and a half years.
Not only were these provisions included in contracts that
were negotiated at arm's length, but contrary to Colkitt's
assertions, they also would restore GFL to the position that
it would have held if Colkitt had not breached the notes.

IV. CONCLUSION

For the foregoing reasons, we will affirm the orders of the
district court entered on April 25, 2000, and July 17, 2000.

A True Copy:
Teste:

       Clerk of the United States Court of Appeals
       for the Third Circuit

                               37
