UNITED STATES DISTRICT COURT, SOUTHERN DISTRICT OF NEW YORK.
September 26, 1975.
Beecher, et al.
Able, et al.; Levy v. Douglas Aircraft Company, Inc., et al.; Gottesman v. Leslie, et al.
The opinion of the court was delivered by: MOTLEY
FINDINGS OF FACT AND CONCLUSIONS OF LAW ON THE ISSUE OF LIABILITY UNDER § 11 OF THE SECURITIES ACT OF 1933
MOTLEY, District Judge: These actions, consolidated for trial, are brought on behalf of certain purchasers of a $75 million dollar issue of 4 3/4% convertible subordinated debentures, sold pursuant to an alleged materially false registration statement filed with the Securities and Exchange Commission. The court previously directed that plaintiffs' claims be bifurcated. In the first phase of trial, which resulted in this court's decision dated October 24, 1974, it was determined that defendants had made material misstatements in the challenged prospectus. The next phase of the litigation dealt with plaintiffs' damages sustained as a result of the misleading break-even prediction in violation of § 11 of the Securities Act of 1933.
1. Plaintiffs' right to recover under § 10(b) of the 1934 Act .
Defendants first argue that plaintiffs are not entitled to bring an action under § 10b of the Securities Exchange Act of 1934, when they are already provided with a full right of recovery under § 11 of the Securities Act of 1933. In support of their argument, defendants reason that a private right of action under § 10(b) was judicially created because there was no other available statutory right of recovery for actions prohibited under § 10(b); that in this case a statutory right of recovery is available under § 11; and that plaintiffs should not be permitted to nullify in effect the provisions of § 11 by seeking recovery under the procedurally less stringent requirements of § 10(b) when there is an adequate remedy under § 11. Defendants also suggest that certain dictum by the Supreme Court, in a footnote in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S. Ct. 1917, 44 L. Ed. 2d 539 (1975), indicates that the Supreme Court disapproves of a right of recovery such as that sought by plaintiff in this case.
The court rejects defendants' arguments.
The court does not agree that to permit plaintiffs to recover under § 10(b) would nullify the more stringent provisions set forth for recovery under § 11. Those two statutes, although each applicable to the actions by defendants which are complained of here, provide for two entirely different causes of action. Section 11 of the Securities Act of 1933 is in the nature of a negligent misrepresentation statute. It provides for recovery only in cases involving material misrepresentations in registration statements or prospectuses. The statute of limitations on such actions is set at one year after the miserepresentations should have been discovered, and no more than three years after the offer of the security to the public. Section 13 of the 1933 Act, 15 U.S.C. § 77m. The measure of damages under § 11 is determined by the differences between the price paid for the security and the value of stock at the time of suit, or the price of the stock at the time it is disposed of. Section 11(e), Securities Act of 1933.
In contrast, § 10(b) provides a cause of action for fraudulent misrepresentation; it is not limited to misrepresentations in registration statements and prospectuses, but covers other forms of fraudulent misrepresentations as well. The statute of limitations under § 10b is that of the state in which the action occurred. III Loss, Securities Regulation, pp. 1771-72. Finally, the measure of damages under § 10b is determined by the out-of-pocket rule, which looks to the value received at the time of purchase. Levine v. Seilon, Inc., 439 F.2d 328, 334 (2d Cir. 1971).
These significant differences between Section 11 and Section 10(b) indicate that they are different causes of action, directed at remedying different types of wrongdoings. A private right of action under 10(b) was created in order to provide a right of recovery for fraudulent misepresentations in connection with the puchase or sale of securities. Regardless of whether or not § 11 provides a remedy for other types of misrepresentation, § 10(b) still provides the only right of recovery for fraud. Simply because plaintiffs happen to allege wrongdoing by defendants which entitles them to recovery under both causes of action, does not indicate that the more stringent requirements of § 11 are being nullified. Those requirements still apply to all of those misrepresentation suits which do not involve allegations of fraud, and will continue to apply to this case if plaintiffs are unable to sustain their burden of proving fraud. Where fraud is alleged, however, plaintiffs are entitled to bring suit under § 10(b) as well. Although plaintiffs need not under § 10(b) meet various stringent requirements under § 11, they must sustain a significantly greater burden of proof. Wolfson v. Solomon, 54 F.R.D. 584 (S.D.N.Y. 1972); Rosen v. Bergman, 40 F.R.D. 19 (S.D.N.Y. 1966); Stewart v. Bennett, 359 F. Supp. 878 (D. Mass., 1973); see Fischman v. Raytheon Mfg. Co., 188 F.2d 783 (2d Cir. 1951).
With regard to defendants' suggestion that plaintiffs already have a recovery under § 11 and should not now be entitled to seek another recovery under § 10(b), the court notes that this case does not present any possibility of a double recovery by plaintiffs. No judgment has been entered on plaintiffs' § 11 claims, nor will any judgment be entered until all of plaintiffs' claims under § 11 and § 10(b) have been heard. This procedure is consistent with the arrangements made in conference on October 22, 1974. At that conference, it was agreed that the court should determine that plaintiffs' § 11 claims first, with all of plaintiffs' 10b rights reserved for determination following the resolution of the § 11 claims. Having agreed to such a procedure, defendants cannot now argue that plaintiffs have lost their rights of recovery under § 10(b) simply by having proceeded to trial first under § 11.
2. The fraudulent nature of defendants' misrepresentations .
The court has already determined under § 11 of the 1933 Act that defendants made material misrepresentations of fact with respect to three statements: (a) its prediction that Douglas would break even in fiscal year 1966; (b) its representation of the use to which the proceeds from the sale of debentures would be put; and (c) its failure to disclose its pre-tax loss of $7,517,000. (Findings of Fact and Conclusions of Law dated March 20, 1974, 374 F. Supp. 341.)
The test of materiality under § 10(b) is identical with that under § 11, See Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-54, 31 L. Ed. 2d 741, 92 S. Ct. 1456 (1972); see Escott v. Barchris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968). Because the issues of the falsity and materiality of these representations already have been determined, for the purposes of determining liability under § 10(b) the court need only address those additional elements necessary to prove a violation of § 10(b) which were not necessary to the court's finding of liability of defendants under § 11.
In order for plaintiffs to recover under § 10(b) of the 1934 Act, they must be able to show that the misrepresentations complained of were fraudulent. In determining whether or not the misrepresentations were fraudulent, this court is not limited to examining defendants' intent. Knowledge of falsity, or reckless disregard for the truth may be sufficient. Chris-Craft Industries, Inc. v. Piper Aircraft Corp., 480 F.2d 341, 363 (2d Cir. 1973), cert. denied, 414 U.S. 910, 38 L. Ed. 2d 148, 94 S. Ct. 231 (1973). Mere negligent conduct is not sufficient to permit plaintiffs to recover here. Chris-Craft Industries, Inc. v. Piper Aircraft Corp., supra; SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1096 n. 15 (2d Cir. 1972).
A. The Break-Even Forecast .
At the trial on liability under § 11, the motivation behind the issuance of the breakeven prediction was explored. That prediction as set forth in the July 12, 1966 prospectus was virtually the same as the one contained in a prior press release issued by Douglas Aircraft on June 24, 1966. (Pl's Exh. 16). The press release was issued following a period of rapid trading of Douglas' stock which indicated to Douglas and to Merrill Lynch, the prospective underwriter of the debentures, that certain persons had obtained and were acting upon inside information concerning Douglas' unfavorable earnings reports. In order to provide this unfavorable earnings information to the general public, Douglas decided to issue its press release predicting that the company would break even if fiscal year 1966. (Tr. 822-29). The court finds that the issuance of the prospectus containing the same prediction was motivated by the same intent as the issuance of the press release: to inform the public about the unfavorable earnings report, in order to neutralize the benefit of inside information obtained by certain holders of Douglas' stock. The issuance of the break-even forecast therefore was not motivated by an intent to mislead purchasers of the debentures concerning Douglas' financial prospects for the rest of the year.
The court also finds that defendants did not actually have knowledge that the breakeven forecast materially misrepresented Douglas' financial situation. Defendants had some basis for their break-even forecast. (Findings, 347 F. Supp. at 348-49.) They simply failed to disclose the assumptions upon which that prediction was based.
The court concluded only that a reasonably prudent investor would not have concluded, given the assumptions, that it was highly probable that the forecast would be satisfied. Plaintiffs have not shown that defendant knew that the break-even prediction was false.
Even though defendants did not intentionally or knowingly misrepresent Douglas' financial prospects, they would be liable under § 10(b) if they acted in reckless disregard of whether the statements were true and with a conscious purpose to avoid learning the truth. United States v Abrams, 427 F.2d 86, (2d Cir.), cert. denied, 400 U.S. 832, 91 S. Ct. 64, 27 L. Ed. 2d 63 (1970); United States v. Sarantos, 455 F.2d 877 (1972). The court concludes that under the circumstances of this case, defendants' actions were neither reckless nor undertaken with a conscious purpose to avoid learning the truth.
Reckless conduct has been defined in general tort law as
"... an act of an unreasonable character in disregard of a risk known to [the actor] or so obvious that [the actor] must be taken to have been aware of it, and so great as to make it highly probable that harm would follow. ... [It] tends to take on the aspect of highly unreasonable conduct, or an extreme departure from ordinary care, in a situation where a high degree of danger is apparent, Prosser, Law of Torts, 185-86 (4th ed. 1971).
In the context of actions alleged to be in violation of § 10(b), a reckless misrepresentation can be defined as a highly unreasonable misrepresentation, involving not merely simple negligence, but an extreme departure from the standards of ordinary care, which presents a danger of misleading buyers or sellers that is either known to the actor or is so obvious that the actor must have been aware of it.
In its findings of March 20, 1974, the court reviewed the evidence presented concerning the justification and lack of justification for defendant's prediction that it would break even in fiscal year 1966. The court found that the defendant "had some basis for concluding that it would not have substantial losses for fiscal 1966," and reviewed nine factors giving support to defendants' conclusions. (Findings, 374 F. Supp. at 348-49.) The court went on to find, however, that a "reasonably prudent bond purchaser would not have concluded, from the facts available to Douglas' management at the time the prospectus was issued, that it was highly probable that the forecast would be satisfied in that substantial losses would be avoided in fiscal 1966. ..." (Findings, 374 F. Supp. at 349-50.)
The evidence presented does not permit, and the court's prior findings preclude, a finding here that defendants' conduct constituted reckless misrepresentation and stemmed from a conscious purpose to avoid learning the truth. Although the prediction was unreasonable, in that a reasonably prudent investor would not have concluded that it was highly probable that the forecast would be satisfied, the existence of some basis in fact for making that prediction indicates that defendant's conduct was not so highly unreasonable as to constitute recklessness or fraud. Plaintiffs have failed to sustain their burden of proof with regard to the fraudulent nature of defendants' representations concerning the likelihood that Douglas would break even in 1966.
B. The Use of Proceeds
In its earlier findings, this court held that defendants' representations concerning the use to which the roceeds from the sale of debentures would be put were material misrepresentations. 374 F. Supp. at 355-56. The court also found that "defendant, at the time the prospectus was issued, intended to use substantially all of the proceeds to pay back short-term bank borrowing." 374 F. Supp. at 355.
The court's finding that defendant intended to use the proceeds of the debenture sales to pay back bank borrowings, despite its contemporaneous representations in the prospectus that the proceeds would be used to finance the build-up, of inventories, indicates that defendants' misrepresentations were deliberate and intentional, and constituted a fraud upon the purchasers of the debentures.
C. The Failure to Disclose Pre-Tax Loss
Douglas failed to disclose that it had incurred a pre-tax loss of $7,517,000 for the second quarter of fiscal year 1966. That fact was material, since a reasonably prudent bond investor would have considered the fact important in the making of his decision whether to invest. (374 F. Supp. at 357.)
Defendants clearly were aware or should have been aware of the size of Douglas' pre-tax loss for the second quarter. They knew or should have known that this fact would have been highly significant to investors; it reflected the current financial health of the corporation, and would have indicated that Douglas has substantially depleted its available tax credits. (374 F. Supp. at 357.) In view of the importance of the information concerning the pre-tax loss, the court finds that Douglas' failure to disclose the pre-tax loss was either deliberate or so highly unreasonable as to constitute reckless conduct. Furthermore, because it would have been difficult for the ordinary prudent investor to have figured out the size of the pre-tax loss, 374 F. Supp. at 356 and n. 18, the omission of that fact presented a significant and obvious danger of misleading purchasers of the debentures.
3. Plaintiffs' Reliance Upon Defendants' Representations .
The court already has found that the representations complained of by plaintiffs were material. 374 F. Supp. at 354, 356, 357. Proof of actual reliance upon these representations by the numerous plaintiffs would be impracticable. The court presumes that because defendants' representations were material, plaintiffs would not have purchased the debentures at the rate at which they were offered if they had known the truth. Affiliated Ute Citizens v. United States, supra, at 153-54; Herbst v. Int. Tel. & Tel. Corp., 495 F.2d 1308, 1316 (2d Cir. 1974); Tucker v. Arthur Anderson & Co., CCH FED. SEC. L. REP. P95,107 (S.D.N.Y. 1975); see Chris-Craft Industries, Inc. v. Piper Aircraft Corp., supra, at 374; see Mills v. Electric Auto-Lite Co., 396 U.S. 375, 385, 24 L. Ed. 2d 593, 90 S. Ct. 616 (1970).
For the reasons discussed above, defendants are liable to plaintiffs under § 10(b) of the 1934 Act for their misrepresentations concerning the use of the proceeds from the sale of debentures and concerning the pre-tax loss. Trial with respect to the measurement of plaintiffs' damages under § 10(b) will commence on December 3, 1975.
Submit order on five days' notice.