Case LSS Doc 29 Filed 03/29/16 Page 1 of 28 IN THE UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF DELAWARE. Case No.

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1 Case LSS Doc 29 Filed 03/29/16 Page 1 of 28 IN THE UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF DELAWARE In re KALOBIOS PHARMACEUTICALS, INC., Debtor. 1 Chapter 11 Case No (LSS) GREGORY REA, RTAT LLC, EDWARD H. PAINTER, NANCY RETZLAFF, ARMISTICE CAPITAL MASTER FUND, LTD, ANDREW PIZZO, AND SABINE GRITTI, Plaintiffs, Adv. Case No (LSS) v. Related Docket Nos. 18, 19, 20, 27 KALOBIOS PHARMACEUTICALS, INC., Defendant. DEFENDANT S REPLY MEMORANDUM OF LAW TO ANSWERING BRIEF IN OPPOSTION TO DEBTOR S MOTION TO DISMISS THE ADVERSARY COMPLAINT HOGAN LOVELLS US LLP Peter A. Ivanick Pieter Van Tol John D. Beck 875 Third Avenue New York, NY (212) March 29, 2016 MORRIS, NICHOLS, ARSHT & TUNNELL LLP Eric. D. Schwartz (No. 3134) Gregory W. Werkheiser (No. 3553) Matthew B. Harvey (No. 5186) 1201 N. Market Street, 16 th Floor P.O. Box 1347 Wilmington, DE (302) Counsel to Debtor and Debtor in Possession 1 The last four digits of the Debtor s federal tax identification number are The Debtor s address is 442 Littlefield Ave., San Francisco, CA

2 Case LSS Doc 29 Filed 03/29/16 Page 2 of 28 i. TABLE OF CONTENTS TABLE OF AUTHORITIES... 1 PRELIMINARY STATEMENT... 1 REPLY... 2 Page I. MANDATORY SUBORDINATION UNDER SECTION 510(B) REQUIRES THE DISMISSAL OF PLAINTIFFS TRUST CLAIMS, AS A MATTER OF LAW A. Section 510(b) is properly considered on the Motion to Dismiss because it prohibits the granting of relief on Plaintiffs trust claims B. Section 510(b) mandates subordination regardless of whether a purchase of securities was consummated C. Section 510(b) overrides any implied trust mechanism through which Plaintiffs could exclude the disputed funds from the Debtor s estate II. III. IV. PLAINTIFFS CONCLUSORY ASSERTION OF INTENT IS NOT SUFFICIENT TO ESTABLISH A RESULTING TRUST PLAINTIFFS CANNOT ESCAPE THE DISMISSAL OF THEIR CONSTRUCTIVE TRUST CLAIM IRRESPECTIVE OF THE VALIDITY OF THE SPA COUNTS II AND III MUST BE DISMISSED BECAUSE PLAINTIFFS HAVE NOT SATISFIED THEIR BURDEN TO PLEAD FRAUD WITH PARTICULARITY AS REQUIRED BY RULE 9(B) A. The Third Circuit requires all fraud claims to meet the heightened pleading standards of Rule 9(b) B. Plaintiffs fraud claim in Count III must be dismissed because Plaintiffs fail to allege actual and justifiable reliance with particularity C. Plaintiffs constructive trust claim in Count II also must be dismissed because it sounds in fraud, and is not pled with particularity

3 Case LSS Doc 29 Filed 03/29/16 Page 3 of 28 ii. TABLE OF CONTENTS (Continued) V. OTHER CLAIMS Page CONCLUSION... 21

4 Case LSS Doc 29 Filed 03/29/16 Page 4 of TABLE OF AUTHORITIES Cases Page(s) Cases Branca v. Branca, 443 A.2d 929 (Del. 1982) Evergreen v. Lehman Bros., Inc., 2011 WL (Bankr. S.D.N.Y. 2011) Federico v. Home Depot, 507 F.3d 188 (3d Cir. 2007) Grant v. Turner, No (JAG), 2010 WL (D.N.J. Mar. 12, 2010) Greenly v. Greenly, 29 Del. Ch. 297 (1946) Greenstar, LLC v. Heller, 814 F. Supp. 2d 444 (D. Del. 2011) Hing Q. Lum v. Bank of Am., 361 F.3d 217 (3d Cir. 2004) Hudak v. Procek, 727 A.2d 841 (Del. 1999) In re Ballard, 502 B.R. 311 (Bankr. S.D. Ohio 2013) In re Betacom of Phoenix, Inc., 240 F.3d 823 (9th Cir. 2001) In re Catholic Diocese of Wilmington, Inc., 432 B.R. 135 (Bankr. D. Del. 2010) In re Charter Co., 876 F.2d 866 (11th Cir. 1989) In re Commercial Fin. Servs., Inc., 268 B.R. 579 (Bankr. N.D. Okla. 2001) , 9 In re Conston, Inc., 181 B.R. 175 (Bankr. D. Del. 1995)... 19

5 Case LSS Doc 29 Filed 03/29/16 Page 5 of 28 In re Drexel Burnham Lambert Grp., Inc., 148 B.R. 993 (Bankr. S.D.N.Y. 1992) In re Edghill, 113 B.R. 783 (Bankr. S.D. Fla. 1990) In re Ephedra Prods. Liab. Litig., 329 B.R. 1 (Bankr. S.D.N.Y. 2005) In re Harbor Oil Co., Inc., 12 F.3d 426 (5th Cir. 1994) In re InaCom Corp., No (PJW), 2001 WL (Bankr. D. Del. Aug. 7, 2001) In re Kaiser Group Int l, Inc., 260 B.R. 684 (Bankr. D. Del. 2001) In re Med Diversified, 461 F.3d 251 (2d Cir. 2006)... 5 In re Motels of America, Inc., 146 B.R. 542 (Bankr. D. Del. 1992)... 5 In re Nat l Serv. Indus., Inc., No (MFW), 2015 WL (Bankr. D. Del. June 19, 2015) In re PT 1 Commc ns, Inc., 304 B.R. 601 (Bankr. E.D.N.Y. 2004)... 5 In re Rockefeller Ctr. Properties, Inc. Sec. Litig., 311 F.3d 198 (3d Cir. 2002) In re Stylesite Mktg., Inc., 253 B.R. 503 (Bankr. S.D.N.Y. 2000)... passim In re U.S. Wireless Corp., Inc., 384 B.R. 713 (Bankr. D. Del. 2008)... 6, 8 In re Wash. Mut., Inc., 462 B.R. 137 (Bankr. D. Del. 2011)... 5 Jordan v. City of Philadelphia, 66 F. Supp. 2d 638 (E.D. Pa. 1999)... 1 Montgomery Ward Holding Corp. v. Schoeberl (In re Montgomery Ward Holding Corp.), 272 B.R. 836 (Bankr. D. Del. 2001)

6 Case LSS Doc 29 Filed 03/29/16 Page 6 of 28 MSA Products, Inc. v. Nifty Home Products, Inc., 883 F. Supp. 2d 535 (D.N.J. 2012)... 1 Pension Ben. Guar. Corp. v. White Consol. Indus., Inc., 998 F.2d 1192 (3d Cir. 1993) Peregrine Fin. Grp. Inc., No. 14-A-837 (CAD), 2015 WL (Bankr. N.D. Ill. May 23, 2015) S. Cross Overseas Agencies, Inc. v. Wah Kwong Shipping Grp. Ltd., 181 F.3d 410 (3d Cir. 1999) Seville Indus. Mach. Corp. v. Southmost Mach. Corp., 742 F.2d 786 (3d Cir. 1984)... 14, Travelers Indem. Co. v. Cephalon, Inc., 620 F App x 82 (3d Cir. 2015) Ulloa v. Guam Econ. Dev t Auth., 580 F.2d 952 (9th Cir. 1978) Wilson v. Jacobs, 2014 WL (D.N.J. Jan. 30, 2014)... 1 Rules and Statutes Section 510(b) of the Bankruptcy Code... passim Bankruptcy Rule , Bankruptcy Rule 7001(8)... 3 Fed. R. Civ. P. Rule 9(b)... passim Fed. R. Civ. P

7 Case LSS Doc 29 Filed 03/29/16 Page 7 of Defendant KaloBios Pharmaceuticals, Inc. (the Debtor, Company or Defendant ), by and through its undersigned counsel, submits this Reply Memorandum of Law (the Reply ) to supplement its Opening Memorandum of Law [Adv. Dkt. No. 19] (the Opening Brief ) 2 in further support of its motion to dismiss [Adv. Dkt. No. 18] (the Motion to Dismiss ) the first amended adversary complaint [Adv. Dkt. No. 15] (the Complaint ) 3 in the above-captioned adversary proceeding (the Adversary Proceeding ) and in response to the Answering Brief in Opposition to Debtor s Motion to Dismiss the Adversary Complaint [Adv. Dkt. No. 27] (the Answering Brief ) filed by Gregory Rea, RTAT LLC, Edward H. Painter, Nancy Retzlaff, Armistice Capital Master Fund, Ltd., Andrew Pizzo and Sabine Gritti (collectively, Plaintiffs ). 2 Capitalized terms not otherwise defined herein are given the meaning ascribed in the Opening Brief. 3 On March 25, 2016, three days after Plaintiffs filing of their Answering Brief (a document that made no mention of their intention to seek to further amend their Complaint) Plaintiffs informed the Defendant that they would be filing a motion for leave (the Motion for Leave ) to file a second amended complaint (the Second Amended Complaint ). The Debtor declined to consent to the filing of the Second Amended Complaint and intends to oppose the Motion for Leave because it submitted under the guise of adding two additional causes of action (in violation of the automatic stay), but in substance seeks to re-plead Plaintiffs original causes of action, in a belated and futile attempt to correct the Complaint s numerous deficiencies identified in Defendant s Motion to Dismiss. The Defendant will address the substance of the proposed Second Amended Complaint more fully in its forthcoming opposition to the Motion for Leave. Accordingly, this Reply is filed only in response to the original Complaint and the Answering Brief, which remain extant. The Motion for Leave does not moot the Motion to Dismiss, which may be considered addressed to the Second Amended Complaint to the extent applicable. See Jordan v. City of Philadelphia, 66 F. Supp. 2d 638, 641 (E.D. Pa. 1999); Wilson v. Jacobs, 2014 WL , at *1 (D.N.J. Jan. 30, 2014); MSA Products, Inc. v. Nifty Home Products, Inc., 883 F. Supp. 2d 535, 539 (D.N.J. 2012). Nevertheless, Defendant reserves all rights to provide supplemental briefing and/or a new motion to dismiss if the Court grants Plaintiffs Motion for Leave.

8 Case LSS Doc 29 Filed 03/29/16 Page 8 of PRELIMINARY STATEMENT Plaintiffs incorrectly assert that subordination under section 510(b) is inapplicable because (i) subordination cannot be raised in the context of a motion to dismiss and (ii) their claims do not arise from the purchase of securities because the SPA was never consummated. First, it is section 510(b), not the Motion to Dismiss, that provides for subordination of Plaintiffs claims. Here, Defendant will seek subordination of the claims through the Debtor s plan. As Plaintiffs claims are subordinated by section 510(b), Plaintiffs cannot assert trust claims through the Complaint upon which the Court can grant relief. Thus, dismissal of their trust claims is properly before this Court. Second, Plaintiffs argument that arising from the purchase of securities requires a consummated purchase of securities is based on their reading of a case that has been expressly overturned by the Third Circuit on this very point. The Third Circuit has made clear all that is required is some nexus to the purchase of securities. Here, Plaintiffs claims clearly have some nexus to the purchase of the Debtor s securities as they arise from the purported failure to consummate the SPA to acquire the Debtor s common stock. Additionally, the Court should dismiss Count I (resulting trust) because Plaintiffs provide nothing more than a single conclusory statement of their intent (and no allegation that they had expressed such intent to the Debtor or its alleged agent) for the funds to be held in trust, which is insufficient to state a claim. Count II (constructive trust) also should be dismissed irrespective of whether there is a valid SPA. Either (i) there is no valid SPA to give rise to the alleged fraudulent misrepresentations or breached duties upon which Plaintiffs constructive trust claim is based or (ii) there is a valid SPA containing the allegedly fraudulent misrepresentations and breach duties, the existence of which bars granting relief on a quasi-contractual cause of action like a constructive trust. Under either scenario, Count II cannot survive and should be dismissed.

9 Case LSS Doc 29 Filed 03/29/16 Page 9 of 28 Further, Counts II (constructive trust) and III (fraud arising out of the SPA) must be dismissed because Plaintiffs have not satisfied their burden to plead either claim with particularity as required by Fed. R. Civ. P. Rule 9(b). As Defendant has already shown in its Opening Brief, the Third Circuit requires all fraud claims to meet the heightened pleading standards of Rule 9(b), and Plaintiffs Answering Brief offers no law to support their assertion to the contrary. Since Plaintiffs in their Answering Brief have failed to identify any place in the Complaint where they plead the requisite reliance element of fraud with particularity, their fraud claim (Count III), and the constructive trust claim (Count II), which relies on the same defective fraud allegations, must both be dismissed. Finally, once Plaintiffs trust claims are dismissed, all that remains are their garden-variety claims for fraud, breach of contract, and unjust enrichment, none of which properly forms the basis for a stand-alone adversary proceeding. Plaintiffs dubious attempt to characterize these claims as proceedings to recover money or property that require an adversary proceeding has no basis in law and must fail. Accordingly, the Complaint should be dismissed in its entirety. REPLY I. MANDATORY SUBORDINATION UNDER SECTION 510(B) REQUIRES THE DISMISSAL OF PLAINTIFFS TRUST CLAIMS, AS A MATTER OF LAW. Despite their best efforts to over complicate the action before the Court, Plaintiffs Answering Brief need only be distilled to the opening sentence of its Summary of the Argument: This action arises out of an unconsummated private placement of unregistered shares of Defendant s common stock in December Ans. Br. at 1. This characterization places Plaintiffs claims squarely within the scope of section 510(b). The only two legal issues Plaintiffs Answering Brief requires this Court to determine are: (i) whether it is proper to 2.

10 Case LSS Doc 29 Filed 03/29/16 Page 10 of 28 consider subordination under section 510(b) in the context of a motion to dismiss an adversary complaint and (ii) whether an unconsummated purchase of securities fits within the purview of section 510(b). The case law answers both questions in the affirmative. A. Section 510(b) is properly considered on the Motion to Dismiss because it prohibits the granting of relief on Plaintiffs trust claims. Plaintiffs argue it is somehow procedurally improper and a denial of their due process for the Debtor to move to dismiss on the basis that section 510(b) defeats their claims for relief. Ans. Br. at In support of their erroneous position, Plaintiffs rely upon Bankruptcy Rule 7001 and several cases that, if correctly read, either support the Debtor s invocation of section 510(b) here or simply have nothing to do with the dispute before the Court. Further, Plaintiffs reliance on Bankruptcy Rule 7001(8) in this context is puzzling. Rule 7001(8) provides that an adversary proceeding includes a proceeding to subordinate any allowed claim or interest, except when a chapter 9, chapter 11, chapter 12, or chapter 13 plan provides for subordination. Fed. R. Bank. P. 7001(8) (emphasis added). This, of course, is an adversary proceeding. Nothing in Rule 7001(8) precludes a party from seeking to enforce mandatory subordination under section 510(b) through a motion to dismiss and then in turn seeking to subordinate the claims under a plan. 4 Moreover, and most importantly, Plaintiffs conveniently ignore the two most instructive and directly applicable cases discussing the interplay between implied trust claims and section 510(b), which both did so in the context of a motion to dismiss. See In re Stylesite Mktg., Inc., 253 B.R. 503, 509 (Bankr. S.D.N.Y. 2000); In re Commercial Fin. Servs., Inc., 268 B.R. 579, (Bankr. N.D. Okla. 2001). In Stylesite, a purchaser of the chapter 11 debtor s 4 In any event, Debtor s soon to be filed plan of reorganization will provide for section 510(b) subordination of Plaintiffs claims as expressly permitted by Rule 7001(8). 3.

11 Case LSS Doc 29 Filed 03/29/16 Page 11 of securities brought an adversary proceeding for imposition of a constructive trust for the consideration it had paid, asserting that it had been induced to enter the agreement by trick and deceit. In re Stylesite Mktg., Inc., 253 at 509. The debtor filed a motion to dismiss the adversary complaint, arguing that section 510(b) subordinated the plaintiffs underlying claim, and therefore barred the constructive trust remedy the plaintiff sought. See id. at The Stylesite court framed the issue as follows: The principal question of bankruptcy law raised in this adversary proceeding is whether the plaintiff, a purchaser of the debtor-defendant s stock, can bypass [section 510(b)] by suing to impose a constructive trust on the consideration paid for the securities. Id. at 506. The court then determined that a constructive trust could not circumvent the mandatory application of section 510(b) and therefore the plaintiffs could not state a claim upon which relief could be granted. Id. ( I grant the defendants motion to dismiss the plaintiff s complaint. ). In In re Commercial Financial Services, Inc., the court similarly considered whether section 510(b) prohibited the granting of relief on the plaintiff s trust claim. The court stated that the threshold issue in determining whether to grant CFS s Motion to Dismiss on the ground that BOA s claim is subject to mandatory subordination under Section 510(b) is whether the facts alleged in the Complaint require the Court to conclude, as a matter of law, that the Series Note falls within the statutory definition of claims subordinated by Section 510(b). In re Commercial Fin. Servs., Inc., 268 B.R. at 599 (emphasis added). Although recognizing it could not grant the motion to dismiss on 510(b) grounds because there was a factual dispute as to whether the security at issue was of the debtor or a non-debtor affiliate, the court provided a thorough analysis of the language and legislative intent of section 510(b) and concluded that if

12 Case LSS Doc 29 Filed 03/29/16 Page 12 of 28 the instrument at issue was a security of the debtor, section 510(b) would prohibit plaintiff from asserting a trust claim. Id. at 600. In short, as recognized in Stylesite and Commerical Financial Services, 5 mandatory subordination under section 510(b) prevents the granting of relief on Plaintiffs trust claims and therefore warrants granting the Motion to Dismiss as to Plaintiffs Counts I and II. B. Section 510(b) mandates subordination regardless of whether a purchase of securities was consummated. Plaintiffs second attempt to avoid the application of section 510(b) is based on their assertion that the SPA was not consummated and section 510(b) is inapplicable where a claimant is not an actual shareholder, but instead a creditor. Ans. Br. at 40. Plaintiffs argument is premised on a narrow interpretation of section 510(b) espoused in Montgomery Ward Holding Corp. v. Schoeberl (In re Montgomery Ward Holding Corp.), 272 B.R. 836, 839 (Bankr. D. Del. 2001) and In re Motels of America, Inc., 146 B.R. 542, 544 (Bankr. D. Del. 1992). Ans. Br. at Plaintiffs neglect, however, to inform this Court that neither decision remains good law in the Third Circuit as to the proposition for which they are cited by Plaintiffs. Instead, courts have consistently adopted a broad interpretation of section 510(b) (as the courts in the Third Circuit do) and have unequivocally determined that [N]othing in 510(b) s text requires a subordinated claimant to be a shareholder. In re Betacom of Phoenix, Inc., 240 F.3d 823, 829 (9th Cir. 2001); see also In re Med Diversified, 461 F.3d 251 (2d Cir. 2006) (subordinating claim arising from failure to issue securities pursuant to severance agreement); In re PT 1 Commc ns, Inc., 304 B.R. 601 (Bankr. E.D.N.Y. 2004) (subordinating 5. 5 Similarly misguided is Plaintiffs citation of In re Wash. Mut., Inc., 462 B.R. 137, 145 (Bankr. D. Del. 2011), as a decision purportedly supporting the proposition that an attempt to seek subordination through a motion to dismiss is improper and should not be permitted. Ans. Br. at 38. Washington Mutual actually undercuts Plaintiffs flawed argument because it recognizes that no adversary proceeding is required when, as will be true in this case within a matter of days, the Debtor s plan will provide for subordination of the subject claims. Id. at 145.

13 Case LSS Doc 29 Filed 03/29/16 Page 13 of 28 claim based on failure to issue stock). In determining that an actual purchase or sale of securities is not required to trigger section 510(b), the Betacom court explained: The [policy] rationale [of section 510(b)] applies even if there is no actual sale or purchase. Before they receive any stock or extend a line of credit, investors and creditors have different expectations. Even if an investor never receives her promised shares, she entered into the investment with greater financial expectations than the creditor. The creditor can only recoup her investment; the investor expects to participate in firm profits. Betacom, 240 F.3d at 830 (emphases added). Courts in this circuit have consistently relied on Betacom and interpreted section 510(b) broadly to give effect to the policies underlying subordination. In In re Telegroup, Inc., the claimant-appellants brought a claim against the debtor for breach of a representation that the debtor would use its best efforts to register the shares so they were freely tradable. 281 F.3d 133, 137 (3d Cir. 2002). The claimants argued that section 510(b) should not subordinate their claims because the debtor s breach did not arise out of the actual purchase of securities but occurred subsequent thereto. Id. The Third Circuit held that the arising from language of section 510(b) was ambiguous and therefore undertook several pages of analysis of the text of the statute, its legislative history and the policies underlying mandatory subordination. Id. The court specifically noted the differing approaches represented by Betacom and Montgomery Ward and ultimately concluded those cases applying a narrow interpretation of section 510(b) were simply wrong, 6 instead adopting a broad reading of section 510(b) that the post-purchase conduct arose 6. 6 Since Telegroup was decided, this Court has recognized its express overruling of Montgomery Ward, stating: The Court in Montgomery Ward Holding Corp. limited section 510(b) subordination to claims which directly concern the stock transaction itself. That view has since been overruled in the Third Circuit. In re U.S. Wireless Corp., Inc., 384 B.R. 713, 724 n.70 (Bankr. D. Del. 2008) (internal citations omitted). Further, Judge Walsh s decision in Montgomery Ward, which was later overruled by the Third Circuit in Telegroup, relied expressly upon the district court opinion in Betacom that the Ninth Circuit would later reverse. Montgomery Ward, 272 B.R. at 842.

14 Case LSS Doc 29 Filed 03/29/16 Page 14 of 28 from the securities purchase. Id. at 142. The following passage is particularly compelling and demonstrates why Plaintiffs in this case should fare no better than the claimants in Telegroup: More important than the timing of the actionable conduct, from a policy standpoint, is the fact that the claims in this case seek to recover a portion of claimants equity investment. In enacting 510(b), Congress intended to prevent disaffected equity investors from recouping their investment losses in parity with general unsecured creditors in the event of bankruptcy. Since claimants in this case are equity investors seeking compensation for a decline in the value of Telegroup s stock, we believe that the policies underlying 510(b) require resolving the textual ambiguity in favor of subordinating their claims. Put differently, because claimants retained the right to participate in corporate profits if Telegroup succeeded, we believe that 510(b) prevents them from using their breach of contract claim to recover the value of their equity investment in parity with general unsecured creditors. Id. at 142. Plaintiffs fall into the same trap here instead of focusing on the meaning of the statute and its policy goals, they get caught up in debating whether section 510(b) applies to a claim that, despite possessing a close nexus to a purchase or sale of securities, happens to arise some period before or after such a transaction. Similarly, in In re Kaiser Group Int l, Inc., 260 B.R. 684 (Bankr. D. Del. 2001), Judge Walrath addressed whether section 510(b) subordination was appropriate for claims arising out of the Debtor s failure to issue additional shares of stock as required by a merger agreement or to pay them additional cash. The claimants argued that section 510(b) was inapplicable to their claims because they were not seeking damages relating to the issuance of stock but instead for the breach of the debtors contractual obligation to pay cash or issue additional shares to assure the full merger value under a merger agreement. Id. at 687. Expressly relying on Betacom, Judge Walrath rejected this position, stating that the obligation to pay the merger value was an obligation undertaken by the debtors in connection with the issuance of their stock and as a guarantee by the debtors of the value of their stock, which clearly 7.

15 Case LSS Doc 29 Filed 03/29/16 Page 15 of constitutes a claim based on damages resulting from the sale or purchase of securities of the debtors. Id. In In re U.S. Wireless Corp., Inc., 384 B.R. 713 (Bankr. D. Del. 2008), Judge Sontchi analyzed whether claims arising from the debtor s breach of its former employee s employment compensation package, which included rights to issuances of stock and stock options, was subject to subordination under section 510(b) of the Bankruptcy Code. Because of the former employee s wrongful termination, he had not satisfied certain vesting requirements and therefore was not issued certain equity securities in the debtor. Judge Sontchi expressly relied upon Betacom to determine that non-receipt of stock did not bar subordination of his entire claim under section 510(b). Id. at 720 n.46. The above discussed cases, although not directly on point, have all taken a broad view of section 510(b). The facts as Plaintiffs have alleged them sophisticated investors who, by their own admission, negotiated and executed a securities purchase agreement and wired their purchase price funds directly to the Debtor for the intended purpose of acquiring stock are just as much as, if not more so, squarely within the broad interpretation of arising from the purchase or sale of securities than the post-purchase breach in Telegroup, post-merger price adjustment in Kaiser Group Int l or the breach of an employment compensation package requiring the issuance of stock in In re U.S. Wireless Corp., Inc. These cases all involve claimants seeking to recover their equity investment. Plaintiffs here have not and cannot explain why the present facts warrant a contrary result under section 510(b). Importantly, Plaintiffs have cited no case where the failure to finalize a securities contract somehow renders the claimant immune to the application of section of 510(b). Thus, even assuming the SPA was not executed and/or consummated,

16 Case LSS Doc 29 Filed 03/29/16 Page 16 of 28 Plaintiffs and the Debtor were engaged in a transaction for the purchase and sale of the Debtor s common stock. Any claim including a claim whose redress is an equitable remedy such as a trust relating to such purchase or sale of the Debtor s common stock is subject to mandatory subordination to the level of common stock under section 510(b) of the Bankruptcy Code. C. Section 510(b) overrides any implied trust mechanism through which Plaintiffs could exclude the disputed funds from the Debtor s estate. A telling omission from Plaintiffs Answering Brief is their failure to address the merits of In re Stylesite Marketing, Inc., 253 B.R. 503, 510 (Bankr. S.D.N.Y. 2000), and In re Commercial Financial Services, Inc., 268 B.R. 579 (Bankr. N.D. Okla. 2001), two opinions recognizing that when section 510(b) applies to claims, implied trust theories will not prevent a debtor s bankruptcy estate from acquiring a beneficial interest in property. In Stylesite, the court held that a constructive trust cannot circumvent the clear application of section 510(b) and therefore even if [the purchaser] is entitled to a constructive trust, its remedy should still be subordinated to the payment of all other claims. Stylesite, 253 B.R. at 510. The Commercial Financial Services decision likewise recognizes the primacy of section 510(b) over section 541(d) when, as here, mandatory subordination applies. The Court should reach the same result and hold that the Funds are property of the Debtor s estate. 9. II. PLAINTIFFS CONCLUSORY ASSERTION OF INTENT IS NOT SUFFICIENT TO ESTABLISH A RESULTING TRUST. Even assuming there was no valid SPA (which as discussed below in Section III, Plaintiffs inconsistently assert), Plaintiffs have still only asserted a single conclusory statement of their intent for the funds to be held in escrow, which is not sufficient to state a claim for

17 Case LSS Doc 29 Filed 03/29/16 Page 17 of resulting trust. 7 Further, according to the Delaware Supreme Court, the device of a resulting trust is imposed by a court of equity to give effect to the presumed intentions of the parties. Hudak v. Procek, 727 A.2d 841, 843 (Del. 1999) (emphasis added). In addition to stating their own intention in a conclusory manner, Plaintiffs have failed entirely to allege that the Debtor intended for a trust relationship to arise when the money was transferred. Plaintiffs admit in the Complaint that: On or about December 3, 2015, KaloBios financial advisor sent Plaintiffs a Securities Purchase Agreement (the SPA ). Exhibit B. Compl. 22; Beginning on December 3, 2015, KaloBios financial advisor sent Plaintiffs disclosure schedules, instructions for wiring payment, a registration rights agreement (the Registration Agreement ), and instructions for Plaintiffs to execute and return the documents. Compl. 33; In compliance with the instructions received from KaloBios financial advisor, each of the Plaintiffs executed and returned the SPA and the Registration Agreement. Compl. 34; Plaintiffs wired $6.9 million of funds to the Debtor per instructions from its financial advisor. Compl Even assuming the Company never countersigned the SPA which is not true as the countersigned version is attached to the Beck Declaration these admissions by Plaintiffs (again, each a sophisticated investor) required the Court to accept the incredible and entirely implausible proposition that they wired $6.9 million to the Defendant with the parties having the completely unexpressed intention that such funds should be held in trust. Plaintiffs have alleged no oral or written communication by which they communicated their intent to the Defendant or where the Defendant has expressed such intent. Indeed, to the contrary, they each executed an SPA 7 Plaintiffs have implicitly acknowledged this deficiency by including in the Second Amended Complaint that their intent for the money to be escrowed was consistent with standard practice in the industry. Second Amended Complaint 84.

18 Case LSS Doc 29 Filed 03/29/16 Page 18 of tendered to them by the Debtor s agent, which could have, but expressly did not, require such funds to be held in trust or escrowed. Plaintiffs contend that they need not state more than this single conclusory statement because a court presumes, absent contrary evidence, that the person supplying the purchase money for property intends that its purchase price will inure to his benefit. Ans. Br. at 26. The cases that Plaintiffs cite, however, arise in much different contexts where the party paying the funds appears on the face of the transaction to not be receiving a benefit despite the circumstances suggesting the payor should have an equitable right in the property. 8 In such instances, courts do presume that the party transferring the money did not do so as a gift. But here, there is no question Plaintiffs paid the purchase price and were the intended recipients of the shares. 9 Even putting aside the overwhelming documentary evidence and taking only Plaintiffs alleged facts, Plaintiffs have pled no facts to support their assertion that they intended the money to be held in trust and should, at most, have a claim against the Debtor for failure to comply with its obligations under the SPA. Thus, intent cannot be presumed and the Court should dismiss Count I. 8 See In re Catholic Diocese of Wilmington, Inc., 432 B.R. 135, 148 (Bankr. D. Del. 2010) (holding that resulting trust existed where religious diocese held funds of individual parishes and charitable and educational organizations in order to invest the funds on their behalf); Branca v. Branca, 443 A.2d 929 (Del. 1982) (holding that funds parents gave to their son clearly constituted a loan, not a gift, entitling them to an equitable lien against home purchased with their funds.); Greenly v. Greenly, 29 Del. Ch. 297, 302 (1946) (holding that in the specific situation where a wife paid consideration for property, but the deed was made to the husband with her consent, it was presumed to be for her benefit, and no gift was intended). 9 The Debtor maintains that the Court may consider the documentary evidence attached to the Beck Declaration on the Motion to Dismiss because they (i) were attached or integral to the Complaint; (ii) discuss events that are a matter of public record; and/or (iii) are indisputably authentic documents on which the claims are based. See S. Cross Overseas Agencies, Inc. v. Wah Kwong Shipping Grp. Ltd., 181 F.3d 410, 426 (3d Cir. 1999); Pension Ben. Guar. Corp. v. White Consol. Indus., Inc., 998 F.2d 1192, 1196 (3d Cir. 1993). But these documents only emphasize the implausibility of Plaintiffs factual assertions in the Complaint and, as discussed herein, are not required in order to dismiss their Complaint solely based on the facts as Plaintiffs have alleged them. Further, the Court may disregard those documents it determines are not properly before the Court, but there is no need to convert the Motion to Dismiss to a motion for summary judgment under Fed. R. Civ. P. 56.

19 Case LSS Doc 29 Filed 03/29/16 Page 19 of III. PLAINTIFFS CANNOT ESCAPE THE DISMISSAL OF THEIR CONSTRUCTIVE TRUST CLAIM IRRESPECTIVE OF THE VALIDITY OF THE SPA. Plaintiffs legal arguments clumsily alternate between those that require the existence of a valid contract and those that are precluded by the existence of a valid contract, conforming their factual assertions as needed to each cause of action. 10 Their constructive trust arguments, however, are clearly premised on the existence of a valid SPA. Specifically, Plaintiffs Answering Brief states that A Constructive Trust Arose Through The SPA, Ans. Br. at 31, and argues that a constructive trust is warranted because the Defendant had a duty to perform under the SPA in good faith. Ans. Br. at 32. Plaintiffs then proceed to list three alleged misrepresentations by the Debtor contained in the SPA that they allegedly relied on and that warrant the imposition of constructive trust. Ans. Br. at 32. But importantly, Plaintiffs fail to explain how an inoperative contract (as they sometimes assert) could impose a duty upon Defendant to perform in good faith or how Defendant could breach representations made in a contract to which it is not yet bound. Instead, it is clear from the face of the Complaint and the Answering Brief that, at least with respect to Plaintiffs cause of action for constructive trust, their position is premised on the validity of the SPA. As discussed in greater detail in the Opening Brief, a constructive trust, which is a quasi-contractual remedy, cannot be imposed when it is premised on the existence of a valid contract. See Stylesite Mktg., Inc., 253 B.R. at 508 ( [T]he refusal to disaffirm the Agreement leaves a valid contract that bars the imposition of a constructive trust. ); see also First Cent. Fin. Corp., 377 F.3d at 213 ( [W]e conclude that this 10 Plaintiffs have alleged Fraud Arising out the SPA (Count III), Breach of Contract (Count IV) and a Constructive Trust claim (Count II) all premised on the valid existence of, and representations made in, the SPA. In contrast, with respect to their cause of action for Resulting Trust (Count I), Plaintiffs assert their intent cannot be derived from the language of the SPA (which contains an integration clause) because the SPA is not an operative agreement. Ans. Br. at 28. Plaintiffs also bring a cause of action seeking unjust enrichment in the alternative to their breach of contract claim if the court determines the SPA was not validly executed. Ans. Br. at 46.

20 Case LSS Doc 29 Filed 03/29/16 Page 20 of principle-that the existence of a written agreement precludes a finding of unjust enrichment-also applies to constructive trust... ). Even more fatally, the issue of the SPA s validity is entirely irrelevant to the analysis of Defendant s Motion to Dismiss Count II because either version of Plaintiffs facts require the dismissal of their constructive trust claim. This is inescapable as either (i) there is no valid SPA to give rise to the alleged fraudulent misrepresentations or breached duties upon which Plaintiffs constructive trust claim is based or (ii) there is a valid SPA containing the allegedly fraudulent misrepresentations and breached duties, but the existence of that valid SPA prohibits a cause of action for constructive trust. 11 Thus, the Court need not determine whether the SPA was validly executed to dismiss Plaintiffs cause of action for constructive trust. IV. COUNTS II AND III MUST BE DISMISSED BECAUSE PLAINTIFFS HAVE NOT SATISFIED THEIR BURDEN TO PLEAD FRAUD WITH PARTICULARITY AS REQUIRED BY RULE 9(B). Plaintiffs in their Answering Brief incorrectly assert that they have complied with the pleading requirements of Fed. R. Civ. P. 9(b) with respect to their fraud claims. As Defendant already demonstrated in more detail in Section VII of its Opening Brief, Plaintiffs have failed to allege actual and justifiable reliance with particularity with regards to their fraud claim (Count III), and therefore, Count III and the constructive trust claim on which it is based (Count II) must be dismissed. 11 Acknowledging this deficiency, Plaintiffs Second Amended Complaint attempts to now consistently assert there was no valid SPA and pleads Breach of Contract in the alternative to the constructive trust claim. However, their constructive trust claim is still inexplicably based on the allegation that the [t]he Company fraudulently induced Plaintiffs to enter into the SPA.... Second Amended Complaint 97.

21 Case LSS Doc 29 Filed 03/29/16 Page 21 of A. The Third Circuit requires all fraud claims to meet the heightened pleading standards of Rule 9(b). Contrary to Plaintiffs assertion in the Answering Brief, the Third Circuit requires plaintiffs pleading fraud in all cases to meet the heighted pleading standards of Rule 9(b). See Travelers Indem. Co. v. Cephalon, Inc., 620 F App x 82, (3d Cir. 2015) ( [When plaintiffs ] theory sounds in fraud, Plaintiffs pleadings must satisfy the stringent Rule 9(b) requirements for particularity ); Federico v. Home Depot, 507 F.3d 188, 200 (3d Cir. 2007) ( Pursuant to Rule 9(b), a plaintiff alleging fraud must state the circumstances of the alleged fraud with sufficient particularity to place the defendant on notice of the precise misconduct with which [it is] charged. (internal quotation marks and citations omitted) (alteration in original)). Plaintiffs contrary assertion misconstrues a Third Circuit decision they claim adopts a relaxed approach to pleading fraud under Rule 9(b). Ans. Br. at 21 (citing Seville Indus. Mach. Corp. v. Southmost Mach. Corp., 742 F.2d 786 (3d Cir. 1984), abrogated in part on other grounds by Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007)). But the Third Circuit has consistently recognized that Seville Indus. does not articulate a relaxed pleading standard, but rather articulates the rationale underlying Rule 9(b) s heightened pleading requirement: to place the defendants on notice of the precise misconduct with which they are charged, and to safeguard defendants against spurious charges of immoral and fraudulent behavior. Travelers Indem. Co., 620 F App x at (citing Seville Indus., 742 F.2d at 791) (internal citation and quotation marks omitted); see also Hing Q. Lum v. Bank of Am., 361 F.3d 217, (3d Cir. 2004) (same); In re Nat l Serv. Indus., Inc., No (MFW), 2015 WL , at *4 (Bankr. D. Del. June 19, 2015) (same). At the same time the Third Circuit has recognized that Seville Indus. articulates the underlying policy of Rule 9(b), it has confirmed that to meet that rule s stringent requirements plaintiffs must allege, at a minimum, the circumstances of the alleged fraud, as

22 Case LSS Doc 29 Filed 03/29/16 Page 22 of well as who made a representation to whom and the general content of the misrepresentation. Travelers Indem. Co., 620 F. App x at (quoting Hing Q. Lum, 361 F.3d at 224). Said differently, Plaintiffs must plead the who, what, when, where and how of the events at issue. In re Rockefeller Ctr. Properties, Inc. Sec. Litig., 311 F.3d 198, 217 (3d Cir. 2002). Plaintiffs attempt to distinguish the heightened pleading standard correctly articulated in the Opening Brief is misguided. While it is correct that Rockefeller stated that where it can be shown that the requisite factual information is peculiarly within the defendant's knowledge or control, the rigid requirements of Rule 9(b) may be relaxed, Rockefeller, 311 F.3d at 216, the court in Rockefeller was not articulating a general relaxed standard applicable to all fraud claims brought in the Third Circuit, but rather a situation-specific standard applicable only to sensitive situations in which sophisticated defrauders may successfully conceal the details of their fraud. Id. Since the information allegedly withheld to induce Plaintiffs to enter into the SPA was widespread in the public forum and not a sophisticated fraudulent scheme as in Rockefeller, 12 the case currently before this Court is plainly not one where the requisite factual information is peculiarly within the defendant's knowledge or control, and therefore the relaxed standard from Rockefeller does not apply here. 12 As Plaintiffs concede, courts are permitted to take judicial notice of the existence of matters contained in records in the public realm at the time. Ans. Br. at 17. Thus, the Court may take judicial notice that the Bloomberg articles attached as Exhibit P to the Beck Declaration discussing Shkreli s ongoing investigation existed in the public realm at that time the parties entered into the SPA (and a simple Google search will render countless more public articles). Plaintiffs cannot maintain their claims for fraudulent inducement based on their unbelievable assertion that Plaintiffs (all sophisticated investors and many of whom had direct ties to other Shkreli business ventures) were entirely unaware of Shkreli s criminal investigation and relied on Defendant s representation. See Travelers Indem. Co., 620 F. App x 82, 86 n.4 (rejecting Plaintiffs argument that the Rule 9(b) particularity requirements should be relaxed where [d]efendants did not have exclusive control over significant information ).

23 Case LSS Doc 29 Filed 03/29/16 Page 23 of B. Plaintiffs fraud claim in Count III must be dismissed because Plaintiffs fail to allege actual and justifiable reliance with particularity. Plaintiffs allegations of reliance in the Complaint consist solely of cursory, conclusory allegations that fail to allege actual and justifiable reliance with sufficient particularity for Plaintiffs to satisfy their pleading burden under Rule 9(b). 13 Plaintiffs attempt to overcome the requirements under Delaware law for pleading reliance by aligning themselves with the plaintiffs in Greenstar, LLC v. Heller, 814 F. Supp. 2d 444 (D. Del. 2011), is unavailing. The court in Greenstar found that the plaintiffs had satisfied their burden under Rule 9(b) to plead reliance with particularity because they had specifically alleged how they relied on the defendant s misrepresentations and how that reliance led to damages. See Greenstar, 814 F. Supp. 2d at 452 (finding sufficient to satisfy Rule 9(b) a pleading that defendant s failure to disclose the adverse regulatory status of property caused plaintiffs to overbid for property). By contrast, Plaintiffs here have merely summarily asserted that they relied on representations and warranties contained in a contract they claim was never even effective between the parties. Further, Plaintiffs make no attempt to address how they could have relied on Defendant s alleged misrepresentations when the information Defendant purportedly withheld was readily and widely publicly available. Accordingly, Plaintiffs have not met the requirements to state a claim for fraud under Delaware law and Rule 9(b) and their fraud claim must be dismissed In their Answering Brief, Plaintiffs identify only two paragraphs in the Complaint where they plead reliance, and in neither paragraph is reliance pled with particularity: Paragraph 75 states that Plaintiffs sent funds to Defendant in reliance on [Defendant s] materially and knowingly false statements ; Paragraph 107 states that Plaintiffs relied on [Defendant s] representations by contracting for closing conditions that were contingent on the representations truth. As Defendant has already pointed out in its Opening Brief, these claims do no more than parrot the reliance element of a claim for common law fraud and are insufficient as a matter of law to satisfy Plaintiffs pleading burden under Rule 9(b). 14 Plaintiffs have re-pled in his issue in their Second Amended Complaint by revising their conclusory statement to be more verbose. See Second Amended Complaint Plaintiffs (all sophisticated investors) still have failed to explain how they reasonably relied on a representation contrary to widely known public information.

24 Case LSS Doc 29 Filed 03/29/16 Page 24 of C. Plaintiffs constructive trust claim in Count II also must be dismissed because it sounds in fraud, and is not pled with particularity. Because Plaintiffs claim for a constructive trust is based on Defendant s alleged fraud, it must be pleaded according to Rule 9(b) s heightened pleading standards. See, e.g., In re Harbor Oil Co., Inc., 12 F.3d 426, 439 (5th Cir. 1994) (finding that Rule 9(b) s heightened pleading requirements applied to a claim for constructive trust premised on allegations of fraud ); Ulloa v. Guam Econ. Dev t Auth., 580 F.2d 952, 959 (9th Cir. 1978) (same); Grant v. Turner, No (JAG), 2010 WL , at *13 14 (D.N.J. Mar. 12, 2010) (same). Plaintiffs have offered no legal support for their assertion to the contrary, only two inapposite authorities, neither of which addresses the type of constructive trust claim presented in this case. First, Plaintiffs rely on Seville Indus, a case which does not address a constructive trust claim at all, but only notes that Rule 9(b)... does not require that every element of an offense that includes fraud also be pled with particularity. Answering brief at 24 (citing Seville Indus., 742 F.2d at 792 n.7). This general principle neither (i) rebuts the many authorities cited in Defendant s Opening Brief that the specific claim of constructive trust, when based in fraud, must be pled according to the requirements of Rule 9(b), nor (ii) applies to the type of claim in this case, which involves an equitable remedy (constructive trust) that has no inherent fraudulent component but which Plaintiffs have chosen to base on Defendant s allegedly fraudulent conduct. Plaintiffs cannot avail themselves of the general principle stated in Seville Indus. without addressing the weight of law that directly addresses the facts of this case and confirms that Count II must be pleaded in accordance with Rule 9(b). Second, Plaintiffs rely on In re InaCom Corp., No (PJW), 2001 WL (Bankr. D. Del. Aug. 7, 2001), a case in which this court held that Rule 9(b) did not apply to a constructive trust claim sounding in contract. In re InaCom Corp., 2001 WL

25 Case LSS Doc 29 Filed 03/29/16 Page 25 of , at *2 (finding that Rule 9(b) does not apply to a constructive trust claim where [plaintiff] alleges injury arising from [defendant] s breach of contract and warranties stemming 18. from [plaintiff] s acquisition of the Division [made pursuant to that contract], not fraud. ). 15 In stark contrast to InaCom, Plaintiffs have brought an independent fraud claim and have explicitly based their constructive trust claim in fraud, not contract, alleging in Count II that [t]he Company fraudulently induced Plaintiffs to enter into the SPA and wire the Funds to the Company. Complaint 94. Accordingly, Plaintiffs cannot rely on InaCom to rebut Defendant s well-supported argument that a constructive trust based on fraud must be pleaded according to Rule 9(b) s heightened pleading standards. Since Plaintiffs have failed to demonstrate why Claim II does not sound in fraud, and have failed to plead fraud in accordance with the requirements of Rule 9(b), Claim II also must be dismissed. V. OTHER CLAIMS As articulated more fully in the Opening Brief, if the Court dismisses Counts I (resulting trust) and Count II (constructive trust), Plaintiffs Counts III (Fraud), IV (Breach of Contract) and V (Unjust Enrichment) merely seek money damages against the Debtor and, therefore, cannot be prosecuted via an adversary proceeding. To circumvent this required procedural result, Plaintiffs attempt to couch their remaining claims as a proceeding to recover money or property requiring an adversary proceeding under Rule 7001(1). Ans. Br. at 45. The practical effect of Plaintiffs position would require every creditor asserting a breach of contract to file an 15 The portions of In re InaCom Corp. cited in the Answering Brief that do address the pleading standards applicable to a fraud claim under Rule 9(b) merely restate portions of Seville Indus., which, as discussed above, does not articulate the correct standard for pleading fraud in this circuit. Further, Plaintiffs fail to mention the portion of In re InaCom Corp. where the court stated that plaintiffs pleading fraud must do more than merely make conclusory allegations of reliance in order to survive a motion to dismiss. See InaCom, 2001 WL , at *3.

26 Case LSS Doc 29 Filed 03/29/16 Page 26 of adversary proceeding instead of a proof of claim. This would be, of course, unworkable, and unsurprisingly is not consistent with the Bankruptcy Rules. Instead, a proceeding to recover money or property as enumerated in Fed. R. Bankr. P. 7001(1) speaks to equitable proceedings seeking to exert dominion and control over money or some physical property the prime example of which is a replevin or turnover action. See, e.g., In re Charter Co., 876 F.2d 866, 874 (11th Cir. 1989); In re Ballard, 502 B.R. 311, 317 (Bankr. S.D. Ohio 2013). Breach of contract, fraud and unjust enrichment are garden variety claims for money damages, and claims for money damages arising from prepetition conduct must be asserted by way of the claims allowance process. See Evergreen v. Lehman Bros., Inc., 2011 WL , *7-8 (Bankr. S.D.N.Y. 2011) (dismissing a claim for breach of contract because the claim should have been asserted in accordance with the claims allowance process, and not by means of an adversary proceeding ); see also In re Drexel Burnham Lambert Grp., Inc., 148 B.R. 993, 998 (Bankr. S.D.N.Y. 1992); In re Edghill, 113 B.R. 783, 784 (Bankr. S.D. Fla. 1990); Peregrine Fin. Grp. Inc., No. 14-A-837 (CAD), 2015 WL , at *4 (Bankr. N.D. Ill. May 23, 2015) In re Ephedra Prods. Liab. Litig., 329 B.R. 1, 7 (Bankr. S.D.N.Y. 2005); In re Conston, Inc., 181 B.R. 175, (Bankr. D. Del. 1995). Plaintiffs contend that the Debtor is elevating form over substance. Ans. Br. at 45. But again, this is not the case. Plaintiffs misguided attempt to bypass the normal claims administration process has already harmed this Debtor by imbuing Plaintiffs with an inflated sense of leverage, resulting in Plaintiffs objecting to nearly every one of the Debtor s substantive filings no matter how minor. The Debtor has been required to devote substantial resources in responding to Plaintiffs various objections and motions. Indeed, over half of the legal fees in each of the legal professionals first monthly fee applications (which Plaintiffs have objected to)