The opinion of the court was delivered by: WEINFELD
This is a motion made upon published and direct mail notice to all beneficial owners on and before February 1, 1975 of the shares and warrants of C. I. Realty Investors (the "Trust"), a real estate investment trust, ("REIT"), for approval of a proposed class action settlement entered into between plaintiffs and defendants. The gross amount of the settlement is $ 925,000 subject to deductions noted hereafter. Upon the return of the motion no class member opposed or questioned the settlement and all parties to the litigation and their counsel urge approval of its terms. Since the affidavits and memoranda submitted in support of the settlement review in detail the history and scope of the litigation, familiarity with the issues involved and the contentions of the parties is assumed.
The proposed settlement encompasses two actions instituted by shareholders of the Trust. The first, Steinberg v. Carey, was filed on January 6, 1975 in the Eastern District of Pennsylvania, and sought damages pursuant to section 10(b) of the Securities and Exchange Act of 1934 ("Exchange Act")
and Rule 10b-5 promulgated thereunder,
on behalf of all those who purchased units, shares or warrants of the Trust from April 13, 1972 to and including July 12, 1972 (the ninety-day effective period) in reliance on the Trust's Registration Statement and Prospectus. The second, Mason v. City Investing Co., was filed in the same district as a combined class and derivative action on February 25, 1975. It asserts claims on behalf of the Trust and its shareholders pursuant to sections 12 and 17 of the Securities Act of 1933 ("Securities Act")
and sections 10(b), 13(a) and 14(a) of the Exchange Act.
The Mason class includes those who purchased the Trust's shares during the period encompassed by the Steinberg action and beyond that is, up to and including February 1, 1975. Both cases were transferred on consent to this district pursuant to 28 U.S.C., section 1404(a). On May 3, 1976, Judge Wyatt dismissed the derivative claims in Mason for failure to make a demand upon the Trust's shareholders prior to bringing suit,
and stayed all discovery on the class claims pending final determination in Steinberg; on August 5, 1976, the Steinberg suit was certified as a class action.
The principal charges in Steinberg centered about the Registration Statement and Prospectus for the Trust's April 13, 1972 offering of 2,600,000 units which were sold to the public for a total of approximately $ 65,000,000. Twenty-five dollars was the purchase price for each unit, which consisted of one share of beneficial interest and one warrant to purchase one share at a price of $ 25. The net proceeds of the offering were to be invested in apartment buildings, shopping centers and office buildings and in short- and intermediate-term construction, development and land mortgage loans. Pending such investments, the proceeds were to be temporarily invested in government debt securities, mortgage-backed securities guaranteed by the Government National Mortgage Association ("GNMA") and certificates of deposit.
The complaint alleged that the Registration Statement and Prospectus were materially false and misleading in that they failed to disclose, inter alia: (1) that the Board of Trustees was a "sham," dominated by Trustees who were affiliated with entities related to the Trust, that is, City Investing Company ("C.I."), which allegedly controlled the Trust, and C.I.'s indirectly wholly-owned co-defendant, C.I. Planning Corp. ("Planning"), the Trust's investment advisor; (2) that the Trust's initial investment in a group of garden apartment complexes referred to as the "Multicon" apartments was made without independent appraisals or adequate on-site inspections, which inspections would have revealed that the apartments had an excessive turn-over rate, were poorly managed and required substantial capital expenditures in order to be maintained in competitive condition; (3) that certain risks were inherent in leverage financing, in construction, development and second mortgage loan investments, and in holding GNMA securities; and (4) that the relationship between C.I. and Planning and the extent of benefits inuring to them under the Advisory Agreement between Planning and the Trust would produce conflicts of interest with the Trust.
The Mason complaint largely repeated the above allegations but expanded the class to encompass all purchasers up to and including February 1, 1975 because the charged misstatements and omissions allegedly continued, and were not corrected, in reports filed with the Securities and Exchange Commission and the New York Stock Exchange and in statements accompanying proxy solicitations during that period. The impetus for both suits was the decline in the market value of the Trust's shares from $ 25 per share on April 13, 1972 to approximately $ 2 per share on December 31, 1974.
The defendants in each action included the Trust, its individual Trustees, Planning, C.I. and two of the managing underwriters for the public offering. The Mason litigation also included the Trust's certified public accountant, Peat, Marwick, Mitchell & Co., as a defendant. All defendants denied and continue to deny the charges levelled against them by plaintiffs.
The proposed settlement was reached after prolonged arms-length negotiations, following extensive and complete discovery by the contending parties, including voluminous interrogatories and document production and depositions of more than sixty witnesses. This case was ripe for trial and the parties were on seventy-two hours notice to proceed when agreement was finally achieved. In substance, the settlement provides for a Class Settlement Fund of $ 925,000, consisting of $ 466,667 contributed by the defendants other than the Trust, and $ 458,333 contributed by the Trust.
From the Fund will be deducted the costs and expenses incurred in giving notice to the respective classes of the proposed settlement; the fees, costs and expenses of administration of the Fund; and attorneys' fees and disbursements in such amounts as are allowed by the Court. The net sum will be distributed to members of the class who have not requested exclusion and whose claims are allowed. There is no provision for refund to the defendants of unclaimed amounts; rather, unclaimed portions will be distributed pro rata to claiming class members.
The function of the Court in reviewing this application, "is not "to reopen and enter into negotiations with the litigants in the hope of improving the terms of the settlement,' nor is the court called upon to substitute its business judgment for that of the parties who worked out the settlement. Rather, in substance, it is called upon to evaluate the probabilities of success upon a trial and to compare the benefits thereof with the terms of the compromise."
As to the first factor, the probability of success, a number of developments in the law and in the marketplace subsequent to the filing of the complaints herein present substantial obstacles to a successful prosecution of the action. In addition to the normal trial risks associated with complex securities cases, the Steinberg action, which was premised on section 10(b) of the Exchange Act, is further encumbered by the problem of proving scienter. The Supreme Court's decision in Ernst & Ernst v. Hochfelder,
requiring proof of intent to deceive, manipulate or defraud, was handed down almost two years after the complaint was filed. Fully aware of the liberality accorded requests to amend pleadings, this Court nonetheless denied plaintiffs' motion to add claims under sections 11 and 12(2) of the Securities Act,
made on the eve of the termination date of all discovery, in light of the substantial prejudice to defendants.
Subsequently, a motion for summary judgment was made on behalf of the "outside" trustees, those who had no other relationship to the Trust or its related companies. Although this Court applied the standard of recklessness which had prevailed in this Circuit prior to Hochfelder,
it nonetheless granted the motion in favor of three of the trustees on the ground that plaintiffs had failed to adduce any fact or circumstance that would warrant "the inference that the outside trustees, . . . acted with reckless indifference to or in callous disregard of their duties as such trustees."
As to plaintiffs' claim with regard to the Multicon garden apartment complexes, which counsel admits was a major part of plaintiffs' case, the exhaustive discovery produced evidence of only questionable probative value for example, the allegedly high turnover rate could be interpreted in negative terms as having a destabilizing effect on the apartment community, or in positive terms as enabling the owners to raise the rent more frequently and generate higher profits. Further, on this motion defendants have shown that of the twenty-five properties purchased, fourteen were sold in 1976 at a profit to the Trust of $ 2,496,423 and no write-down of the remainder of the properties on the company's books has been required.
As to the allegations concerning certain risk factors and potential conflicts of interest, plaintiffs concede that some disclosure was made.
They therefore faced the more formidable task of convincing a jury that the additional disclosure they urged, in light of the total mix of information already available, was material, rather than "excessively detailed or cumulative,"
and that defendants' contrary determination was intentionally or recklessly misleading. Plaintiffs are aware of further obstacles to a successful result upon a trial since there is no direct evidence to support their charges and perforce they would be compelled to rely upon inferences to be drawn from circumstantial evidence which might not be readily accepted by a jury.
Finally, plaintiffs' difficulties are compounded by the requirement of proof of damages and the attendant issue of the appropriate measure thereof, even were they to prevail on the merits. "Two theories of damages for defrauded buyers have been used in this circuit: out-of-pocket losses and the difference between purchase price and subsequent resale price."
The former measure is the usual one, representing the difference between the price paid and the true value of the shares received.
The latter measure, referred to alternatively as "gross economic loss" or "rescission damages,"
is the one plaintiffs have consistently urged.
Admitting that the application of this measure has largely been confined to broker-fraud cases,
in which the plaintiffs have established by direct testimony that they would not have purchased the securities at all had the full facts been known, plaintiffs here indicate that they would have depended on expert testimony to prove that a reasonable person would not have purchased the Trust's shares if full disclosure had been made. There is the initial risk, of course, that such testimony may not be accepted. Moreover, it is far from clear that expert testimony as to what a reasonable investor would have done is sufficient to justify transplanting the rescission measure from its present context of individual face-to-face transactions to the class action setting.
It is certainly questionable that every class member would have refrained from purchasing at Any price rather than from purchasing at an inflated price.
Additional problems are presented by the alternative measure, that is, recovery of "out-of-pocket" losses. In determining the "true value" of the shares received, federal courts have identified two dates: the date of the purchase and the date when the fraud was or should have been discovered.
Defendants urge the former and contend that since the Trust had not begun active operations at the time of the 1972 public offering, "the shareholders . . . were investing in a pool of assets consisting of real properties, mortgages and temporary investments. The value of these assets was increased when combined in an organizational structure that permitted relatively small investors to acquire an interest in these assets. Under these circumstances, the value of the Trust's securities was what plaintiffs paid for them."
The rationale for looking instead at trading prices shortly after public discovery of the seller's fraud is that prior to that time the market has been artificially inflated by the misrepresentations. Although the trading prices for the Trust's shares began to decline within the year following the offering, the substantial drop in value that precipitated this suit did not occur until 1974 and 1975. Plaintiffs have made no attempt to identify a point in time when the misrepresentations they allege were or should have been publicly discovered. Moreover, it is likely, as defendants contend, that the post-offering decline in trading price is not indicative of the true value of the Trust's shares uninflated by alleged misrepresentations, but rather reflects the general decline in the REIT industry. On this point, they offer the NAREIT Stock Price Indices and S&P REIT Indices for the relevant time period to show that the decline in market price of the Trust's shares followed a general decline in the REIT market and that the present price for the Trust's shares, which is only slightly less than the original offering price, far exceeds the relevant market indices. If plaintiffs' recovery were offset to eliminate losses not caused by the alleged violation,
then the real possibility is raised, as counsel concedes, "that even after any finding of liability, plaintiffs and the class would recover no damages."
"When all these dubieties are considered in combination, as they must be,"
the obstacles to ...