The opinion of the court was delivered by: LASKER
This suit raises important questions regarding the application of federal securities laws to the sale of commercial paper. It is one of a number of actions by persons who in the Spring of 1970 bought commercial paper issued by the Penn Central Transportation Company (Penn Central, or the Company) from the defendant, Goldman, Sachs & Co., which was the exclusive dealer in the securities.
The plaintiff, University Hill Foundation (University Hill or the Foundation), purchased two notes in the aggregate face amount of $600,000. which were to mature on September 25, 1970. At maturity the notes were duly presented, but payment was refused for, as is well known, on June 21st the Company had filed a petition in bankruptcy. The Foundation alleges that in the sale of the paper Goldman, Sachs violated § 12(2) of the Securities Act of 1933, 15 U.S.C. § 77l(2), § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and Rule 10b-5 promulgated thereunder, and a variety of state statutes and the common law.
It is claimed that Goldman, Sachs falsely represented both that Penn Central was creditworthy and that Goldman, Sachs had performed an adequate credit investigation, and, further, that Goldman, Sachs omitted to disclose at least six items of information necessary to render the statements made not misleading. Specifically, Goldman, Sachs is charged with failing to disclose:
1) That one month before the sale, upon receipt of a negative financial report from Penn Central, the defendant reduced its inventory of this paper by $10,000,000. by selling it back to the Company;
2) That the "Prime" rating of Penn Central paper by the National Credit Office (NCO) was not based upon NCO's independent evaluation of the paper but upon Goldman, Sachs' decision to continue selling it;
3) That for seven months prior to the sale Goldman, Sachs had unsuccessfully attempted to get Penn Central to increase its bank line coverage for its commercial paper from 50% to 100%;
4) That prior to the sale a major banking institution had removed Penn Central from its list of approved issuers;
5) That Penn Central was in a very tight cash position, lacked working capital and was experiencing increasing losses; and
6) That Penn Central was using the proceeds from the sale of commercial paper to finance non-current transactions.
Finally, the Foundation asserts that in order to prevent the collapse of the commercial paper market, Goldman, Sachs engaged in a fraudulent scheme or course of conduct to withhold negative information about Penn Central until the Company should become financially sound. The Foundation seeks to rescind the sale.
Goldman, Sachs vigorously denies the allegations. According to it, the only representation it made was that at the time of the sale to the Foundation Goldman, Sachs reasonably believed Penn Central to be creditworthy, and it steadfastly continues to maintain that this statement was true. Conceding that the $10 million buy-back of its Penn Central commercial paper inventory could, when isolated from the business context, be interpreted to reflect negatively on its motives, Goldman, Sachs insists that there were sound business reasons for this transaction which had nothing to do with a loss of faith in the Company's paper. With regard to the NCO "Prime" rating, Goldman, Sachs argues that it had no reason to believe that the rating was not based on NCO's independent evaluation of the paper. As for the other alleged omissions, the defendant maintains that they were for a variety of reasons not material in the circumstances of this transaction.
The action was tried to the court without a jury. In addition to six full days of testimony the parties submitted numerous depositions and portions of the testimony in one of the related cases, Franklin Savings Bank v. Levy, et al., 406 F. Supp. 40 (S.D.N.Y. 1975). (Hereinafter FSB v. Levy.) In order properly to evaluate the respective contentions of the parties it is necessary, in addition to discussing the facts of the sale here in issue, to describe the workings of the commercial paper market, Goldman, Sachs' role in that market as an exclusive dealer, and the interaction between Penn Central and Goldman, Sachs in the months preceding the sale.
The Foundation is a California non-profit corporation based in Los Angeles, primarily engaged in raising funds for Loyola University. In March, 1970, and for about two years prior to that time, Howard B. Fitzpatrick, an industrial paint contractor, served as the Foundation's President. He donated ten hours a week to the Foundation, where he had sole responsibility for its daily affairs and for its investments. The Foundation's only employee was a part-time secretary.
From time to time Fitzpatrick decided to purchase commercial paper for the Foundation. These investments were made through one of the Foundation's several banks. When contemplating such a transaction, it was his practice to contact the investment department of at least two banks, find out what paper was available and select the item which best fitted the Foundation's requirements in terms of safety, rate of return and maturity. (106) (Unless otherwise indicated, numbers appearing in parentheses refer to pages of the trial transcript.) He then communicated this decision to one of the banks, which handled the actual purchase of the paper. One of the institutions so employed by Fitzpatrick was the Union Bank of Los Angeles. The official there with whom he dealt was Noel G. LeMay, Vice President in charge of the short-term money market operations of the bank's investment division.
Goldman, Sachs is a partnership in the business of investment banking, underwriting, securities brokerage and related financial activities. Its principal office is in New York City and it maintains offices in Los Angeles as well as other major cities. Since its inception in 1869 Goldman, Sachs has been a dealer in commercial paper. At the time of the transaction in issue, Goldman, Sachs was the largest of six such dealers.
The partner in charge of the Commercial Paper Department was Robert G. Wilson. Wilson was responsible both for the daily buying and selling operations and for the decision to accept or terminate corporate clients who wished to issue commercial paper. This decision hinged in large part on Wilson's assessment of the financial condition of the issuer, or its creditworthiness, a term dealt with extensively below. In making an evaluation of creditworthiness Wilson placed heavy reliance on Jack A. Vogel, the Manager of the Credit Department, a sub-unit of the Commercial Paper Department. Vogel supervised the work of five credit analysts whose function was to assist in the initial investigation of prospective issuers, to monitor the financial condition of the issuers whose paper Goldman, Sachs sold and to put together information of credit significance for periodic distribution to commercial paper purchasers.
B. The Commercial Paper Market and the Sale to the Foundation
The commercial paper market facilitates the flow of cash from lenders with temporary surpluses to borrowers with temporary deficits. Commercial paper consists of unsecured promissory notes usually having a maturity which does not exceed nine months. Corporations of sufficient size and reputation to attract purchasers of these general obligations can normally sell their paper at rates which enable them to meet their short-term borrowing requirements for less than they would have to pay for bank loans. The notes are sold on a discount basis and offer attractive short-term investment for corporations and others with substantial temporary cash excesses. The excesses must be substantial because paper is available only in large dollar units. (The average transaction involves $1 million (237), and in Penn Central's case, a $100,000. note was a small sale. (See Defendant's Exhibit CU.))
Because of the large amounts involved buyers understandably desire to complete the transaction on the date of the sale to avoid losing a day's interest, (260-61) and since the actual mechanics of delivering the notes to the buyer's bank are somewhat cumbersome, the selling day is compressed into a two-and-a-half to three hour period from roughly 9:30 A.M. to 12:00 or 12:15 P.M. During this period the sales force at Goldman, Sachs alone puts together four to five hundred transactions, (274) virtually all of which are completed in a series of brief telephone conversations between the purchaser, the purchaser's agent, if he has one, a commercial paper salesman and a commercial paper buyer.
The transaction involved in this case was typical. (274) Fitzpatrick knew that the Foundation had a $600,000. investment about to mature in an account at Union Bank. He called LeMay to inquire what commercial paper was available with a maturity of approximately six months as a successor investment. LeMay, in turn, called several commercial paper dealers, including the salesmen at Goldman, Sachs' Los Angeles office, to ask what paper was for sale. (14-15) The Goldman, Sachs salesman mentioned three or four issues which met Fitzpatrick's requirements, called a commercial paper buyer in his department to verify that the notes were still on hand and then confirmed to LeMay that the paper was in fact available for sale. (253-55, 274) LeMay at that point reported back to Fitzpatrick and the latter, recognizing Penn Central as a "huge industrial company" and assuming it to be "as safe as the United States Government" (113) elected to take the Company's notes. Accordingly, LeMay placed the order with Goldman, Sachs. Just as Goldman, Sachs' salesmen were answering numerous calls, LeMay also was dealing with as many as a hundred inquiries from bank customers in the three hour selling period. (35) Each of the phone conversations was therefore short and to the point, lasting from thirty seconds to no more than several minutes.
Due to the compressed and somewhat hectic nature of the selling day, it is not the practice for salesmen to engage in lengthy discussions with prospective buyers regarding the financial status of the various issuers. Like securities salesmen everywhere, in the brief time available, they may communicate such information as they possess about their current stock and endeavor to answer specific queries with regard to particular facts of an issuer's financial condition. To assist them in this task the salesmen have ready access to various summaries of credit information prepared by Goldman, Sachs' Credit Department designated respectively white sheets, yellow sheets and green sheets.
During the period in which these notes were sold the salesmen were informed daily by their superiors which particular issues were in plentiful supply in the Goldman, Sachs inventory. Because it was costly to maintain inventory, see slip op. at 14-16, infra, the sales force was encouraged to make a strong effort to sell these issues. (267-70; Defendant's Exhibit DX. And see Frederickson Deposition, 39-41; Coleman Deposition 33-36)
If a prospective investor desires to base his decision on a detailed analysis of the soundness of a particular issuer, he must acquire the information and perform the analysis himself. Many large institutions which regularly invest in commercial paper follow this practice and maintain constantly revised approved lists which are strictly observed. Other investors choose to rely on what are thought to be ready indices of creditworthiness, such as a "Prime" rating by the NCO, a division of Dunn & Bradstreet, or the percent of outstanding paper an issuer has covered with bank lines. (Bank lines are open lines of credit to be made available to pay off maturing paper in the event that the company is unable to do so by other means. They are discussed in more detail below.) Still other investors rely exclusively on the good name of the dealer from whom they buy in the belief that the decision of a reputable dealer to sell the paper of a particular issuer is sufficient evidence of reliability of the security.
Apart from the return rate and maturity date, Fitzpatrick's sole criteria in selecting paper was safety. Accordingly, he had a clear understanding with LeMay that he was only interested in "quality" paper. He always insisted that the paper he bought be "prime", and he used the word in the "lay" sense. (109-10, 132) The instruction to LeMay, insofar as it resulted only in the purchase of paper rated "Prime" by the NCO, was unnecessary, because it was the policy of the Union Bank when buying for customers' accounts only to purchase "Prime" rated paper unless specifically instructed to the contrary by the customer. (5, 8, 29) Apart from the requirement of a "Prime" rating, however, LeMay relied entirely on the dealers' reputation in purchasing on behalf of customers. He was aware that Goldman, Sachs had a credit department which investigated issuers and he knew the defendant to be a "quality house." (65) So long as it was NCO prime, what was "good enough for Goldman, Sachs was good enough" for him. (67-69) The Goldman, Sachs salesmen with whom LeMay dealt knew, or were at least generally aware, that he was only interested in "Prime" rated paper. (8; see Coleman Deposition 112-14; Frederickson Deposition 91-92) On the date of the sale in question, LeMay asked no questions and sought no assurances about the Penn Central paper other than to note that it was NCO "Prime."
C. Penn Central's Relationship with Goldman, Sachs
In February, 1968, the Pennsylvania Railroad merged with the New York Central Railroad to form the Penn Central Company.
The merged entity was the largest transportation company in the world. In addition to its vast railroad properties, the Company had extensive holdings in real estate, and its total assets were valued at more than six billion dollars. The two constituent companies had a history of financial difficulties and it was anticipated that the merger would facilitate a recovery by enabling substantial economies and providing a base for a broad diversification program. However, although hope for the future was high, it was generally expected that it would be several years before the trend of losses in the railroad business would be reversed.
Early in 1968, as part of the Company's plan to finance cash needs in the early years of its new life, Penn Central sought and obtained ICC approval to issue $100 million of commercial paper, and approached Goldman, Sachs, which had sold paper for the New York Central, to act as its dealer. Prior to accepting the Penn Central account Goldman, Sachs performed a credit analysis to assure that the Company was creditworthy, (i.e. which is to say,) that it had the capacity to pay the notes as they matured. Essentially, such an analysis requires examination of a company's access to cash in the near future either through anticipated earnings, lines of bank credit, anticipated long-term financing or assets which can be readily pledged or sold. (554-55; 565-70; 857)
In view of the extraordinary size and complexity of the merged corporation, and also of the fact that it was a new untried entity comprised of two very troubled organizations, Vogel assumed primary responsibility for the analysis himself. (556-57) From time to time over a period of months he reviewed the available data on the Company, including press reports, published financial services, Company applications to the ICC, applications and filings with the SEC, annual reports from prior years, information from Goldman, Sachs' Research Department and other broker-dealers, lists of the Company's banks and lines of available credit and information obtained from contacts with Penn Central management by people at Goldman, Sachs. (481-82) On the basis of Vogel's review, he and Wilson agreed that Penn Central had ample resources to pay its debts and Goldman, Sachs agreed to act as the exclusive dealer in the Company's paper, which became available on August 1, 1968. The following March, the ICC approved Penn Central's request to sell another $50 million of paper for a period through September, 1969.
By the Fall of 1969 both Penn Central and Goldman, Sachs were experiencing certain problems which created a faint tension in their generally amicable business relationship. It was a period of rising interest rates and access to credit was increasingly difficult. This created problems for the management of Penn Central, whose task it was to raise money to finance the deficits which the Company continued to experience at a time when many of its assets were already heavily encumbered. After an encouraging record in 1968, the first two quarters of 1969 showed marked reversals.
The Company's cash position was tight, it had a deficit working capital position and its losses were increasing.
In mid-September 1969, Wilson and Vogel met with John O'Herron, Penn Central's new Vice President for Finance, and several other Company officials. The meeting was held at Wilson's request after learning of the Company's decision to seek ICC approval to continue to keep out the additional $50 million commercial paper and to authorize a second $50 million increase as well, a decision apparently motivated by the increased demand for cash. Before agreeing that such an increase was wise Wilson wished to review the Company's financial position and plans with O'Herron to satisfy himself that the added float of paper would not be an overextension of the Company's resources.
Among the topics of discussion was bank line coverage of the Company's paper. At the time, the Company had $100 million of bank lines, that is, open lines of credit available to meet maturities of commercial paper in the event that new sales were inadequate to do so, to cover its $150 million of commercial paper outstanding. O'Herron announced his intention to continue his coverage at the $100 million level after the outstandings increased to $200 million. Wilson suggested that investors were looking at bank line coverage as a guide to purchasing decisions and inquired whether O'Herron could increase the coverage by $50 million. O'Herron responded that he could, but because of the expense involved
he preferred not to, and he argued that there was no reason to require such an increase in view of the Company's other sources of available cash should it ever be required. Wilson accepted the response, agreeing for the time that in terms of safety there was no need to increase the lines, but stating that he would report back to the Company on any market resistance which might be caused by the 50% line coverage. O'Herron added that the Company's cash position through the 1st quarter of 1970 would be very tight and asked Goldman, Sachs to keep out as much paper as possible until April or longer. (858-63) (Plaintiff's Exhibit 20; Plaintiff's Exhibit 35)
The problem which was developing for Goldman, Sachs in the Fall and Winter of 1969-70, stemmed from its traditional mode of doing business. Historically it had always operated its commercial paper business on an "inventory" basis, purchasing whatever amount of notes an issuer customer wished to sell in a given period, reselling them as a principal and retaining the unsold excess in its own inventory. (275) The practice provided Goldman, Sachs with a stock of paper of varying maturities and interest rates available for immediate delivery and additionally provided an important banking or underwriting service to issuers, assuring them of a desired level of outstandings and advancing them cash on the unsold notes. (275; Defendant's Trial Memorandum 21-22)
As interest rates steadily increased, however, the cost of doing business in this fashion became a serious concern to Wilson and his colleagues in the commercial paper department. Investors were able to bargain for precisely the maturity dates they desired and for better rates of interest, and the inventory of pre-set notes often went unsold in favor of notes sold on a "special order" and "tap issue" basis.
In order to sell notes which accumulated in inventory, Goldman, Sachs often found it necessary to lower the price, i.e., to increase the rate of return, often selling at a lower figure than it initially paid the issuer. This practice is called "distress selling." (276-77; 304) In addition to the problem of distress sales, the defendant also experienced what it termed a "negative carry" cost on the inventory, which refers to the difference between the rate of interest Goldman, Sachs was forced to pay to finance the inventory and the often lower rate of interest it received on the notes themselves. (276; 687-89) As a result of these expenses, the management committee of Goldman, Sachs imposed a limit of $250 million on the total amount of paper the commercial paper department was allowed to inventory at any one time. (690-91) This, in turn, created a constant pressure on Wilson to reduce the inventory of issuers with large inventory positions. (881)
Penn Central was one of the issuers which frequently was high on Goldman, Sachs' inventory list. (See Defendant's Exhibit CW) Throughout the Fall, Wilson continued to encourage the Company to increase its bank line coverage in an effort to enhance the saleability of the notes, and the Company continued to resist the suggestion. O'Herron's feeling was that 50% coverage was perfectly adequate and normal, that increased lines would be too expensive and that in view of the heavily financed condition of the Company he preferred not to ask the banks for additional credit at that time. He desired instead to raise money through the Company's highly profitable non-railroad subsidiary, the Pennsylvania Company, (Pennco), until long-term financing could be arranged. (O'Herron Deposition, May, 1973, 48) (And see 443; 894)
On October 20th, Penn Central's third-quarter earnings were announced, and they reflected a continued deterioration. For the first time the Company reported a consolidated loss, which was $8.9 million (as compared to earnings of $15.2 million for the third-quarter of 1968), and the parent railroad lost $19.2 million (compared to a $3.8 million loss for the same period in the previous year). Consolidated earnings for the first nine months were $17.6 million, down from $52.2 million, and the railroad showed a loss for the year so far of $40.2 million, against a 1968 nine month loss of only $747,000. These figures were widely reported in the financial press. Two days later, O'Herron spoke to Wilson on the phone and assured him that the fourth quarter figures would be "'in the black' with good improvement," saying that the ICC was expected to approve the additional $50 million in commercial paper imminently. (Plaintiff's Exhibit 33) Authorization finally was granted in early November,
and by December 1, the Company had obtained $200 million in "outstandings." ($21.85 million of which was in ...