Appellants appeal from a judgment entered in the United States District Court for the Southern District of New York, Charles S. Haight, Jr., Judge, which granted the motions of appellees for directed verdicts in their favor and dismissed with prejudice appellants' class action complaint. Appellants' complaint asserted violations of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, thereunder, in connection with a sale to appellants and the class they represent of 80,000 shares of stock of a Real Estate Investment Trust called Guardian Mortgage Investors, allegedly without disclosure of material inside information said to have been "tipped" to the sellers. Reversed and remanded for a new trial.
Before Oakes and Meskill, Circuit Judges, and Sifton, District Judge.*fn*
This appeal arises from allegations that a real estate investment trust, or REIT, with approximately $400,000,000 in assets, known as Guardian Mortgage Investors, or GMI, on the eve of the issuance of its annual audit results in the spring of 1974, disclosed to one of its principal financial advisors, Lehman Brothers Incorporated, that the REIT's "problem loans" had increased in the three months since its last public statement on the subject from $7,000,000 to $16,000,000 or $18,000,000. This inside information, it is alleged, was passed on by the brokerage firm to The State Teachers Retirement System of Ohio Pension Fund, another Lehman Brothers' client, which thereafter sold 80,000 shares of the REIT's stock to plaintiffs and the class they represent by means of a secondary offering, managed by Lehman Brothers, without disclosure of the inside information to the purchasers. Nine days after the secondary offering, the REIT made public information that it was substantially increasing its loss reserves and that its dividends would be substantially lower than those paid the preceding year. As a result, the stock fell precipitously and plaintiffs suffered an immediate loss on their investment.
At the conclusion of plaintiffs' case the court below dismissed plaintiffs' complaint, which alleged violations of § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, thereunder, and granted motions for directed verdicts in favor of Lehman Brothers and its pension fund client. The court concluded that the jury could not rationally find that the inside information said to have been "tipped" by the REIT to Lehman Brothers and by Lehman Brothers to the pension fund was material, or that Lehman Brothers and its client acted with an intent to defraud or to deceive in selling the 80,000 shares of the REIT's stock to the uninformed public. Since our examination of the record reveals evidence on the basis of which a jury could have reasonably concluded that the "tip" was material and that the sale by the "tippees" was accomplished with knowledge of the tip's materiality and with fraudulent and deceptive intent to take advantage of the public's ignorance, we reverse in order that the issues raised by plaintiffs' complaint may be resolved by jury.
The economic situation in the context of which this insider "tip" is said to have occurred was characterized, according to the evidence below, by rising interest rates and materials shortages. REITs, which one witness testified make money on the spread between the interest rates at which they borrow from banks and that at which they lend to real estate developers and builders, were generally perceived to be suffering as a result of increases in the prime rate from around 6% In March 1973 to around 10% In March of the following year. Real estate developers who might reasonably be expected to resist increases in borrowing costs which exceeded their expectations appeared particularly resistant to proposals by REITs to pass on to them the higher cost of money as materials shortages led to escalating costs of other supplies. These factors affecting the real estate market in general and the market for REIT stocks in particular were chronicled in detail in the financial press at the time, articles from which were made part of the record below. In the fall of 1973 and spring of 1974 these factors were generally perceived to have resulted in the well publicized failure of one prominent real estate developer and thereafter, of a prominent REIT.*fn1
In this context the expression, "problem loans," developed, according to the evidence below, as an expression of somewhat uncertain content which figured prominently in public and private evaluations of the industry and of REIT stocks. According to one witness the expression referred to a spectrum of situations running from loans to builders and developers on which the REIT had stopped accruing interest because of default in payment, to loans in default of which the REIT had taken possession of the underlying real estate or development securing the loan.
The uncertainty as to the situation referred to by the expression, "problem loans," was compounded by well publicized debates within the accounting profession as to the appropriate method of treating problem loans for purposes of auditing and reporting on the financial condition of REITs. As an example, one witness below testified that according to one accounting philosophy the REIT, which upon default protected itself by foreclosing on its real estate security, should be treated as itself a developer and its actual and anticipated losses calculated according to auditing procedures and accounting standards appropriate to that business. According to another philosophy, however, the REIT in such a situation should continue to be regarded as simply a real estate investment vehicle, fully protected against loss on its investment as long as it appeared that on the ultimate realization of the development's expectations, the REIT would suffer no loss on the principal of its loan.
The reason for this lively investor interest in the subject of problem loans and for the coverage in the financial press of differences within the accounting profession in dealing with them was, the jury could have concluded, because of the uncertainty in the minds of the accounting profession as to the appropriate relationship between problem loans and loss reserves and because of the key role played by loss reserves in the evaluation of REIT stocks as investments. While the relationship of an REIT's problem loans to its loss reserves was uncertain and subject to considerable debate, changes in loss reserves were related in a devastatingly simple, almost mechanical way to the price of the REIT's stock. The explanation of this relationship lay in the structure and operation of REITs as dictated by the Internal Revenue Code.
As witnesses testified below, any increase in an REIT's loss reserves could only be established by a corresponding charge to current earnings; REIT earnings were, in turn, related to the REIT's dividends by the requirements of the Internal Revenue Code. In order to qualify as an REIT under the Code, thereby avoiding treatment of its revenues as income for tax purposes, the investment trust was required, Inter alia, to distribute at least 90% Of its otherwise taxable income as dividends. 26 U.S.C. §§ 856-58 (1970) (amended 1976). Moreover, in order to avoid second guessing by the Internal Revenue Service with regard to revenues properly included on its calculation of otherwise taxable income, most REITs, including GMI, made it a practice to distribute dividends equal to their annual revenues. Finally, because REIT stocks were looked to in the investment community primarily for income rather than for gains resulting from capital accretion, the prices of REIT stocks were exceptionally sensitive to changes in dividend levels.
Given this structural sensitivity of the price of an REIT's stock to the level of loss reserves deemed by the REIT and its accountants to be appropriate in the light of its problem loans, it is understandable why at the particular period of time here at issue extraordinary attention was focused by investors on the uncertain subject of problem loans. As one witness testified:
"Problem loans is a designation that began around that time. But at the time beginning around then and in subsequent months, problem loans became the heavy focus of everyone in the securities industry in analyzing the financial condition of an REIT, and problem loans became a normal part of any conversation that you have."*fn2 (J.A. 343.)
In this context, it seems clear that there was substantial basis in the record for submitting to the jury the question whether information concerning the level and the trend pursued by GMI's problem loans was the kind of information which a reasonable investor would want to know before deciding whether to purchase the REIT's stock,*fn3 and, in particular, whether information, that the level of problem loans as calculated by management had increased from $7,000,000 to $16,000,000 or $18,000,000 over a three-month period, would be regarded by a reasonable investor "as having significantly altered the "total mix' of information . . . available" concerning the REIT's financial condition. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449, 96 S. Ct. 2126, 2132, 48 L. Ed. 2d 757 (1976).
Indeed, the manner in which the information was regarded by those privy to it and the importance attached to the information by the recipients after the "tip" could be found to have been given, Cf. S.E.C. v. Bausch & Lomb, Inc., 565 F.2d 8, 18 (2d Cir. 1977), were entirely consistent with a conclusion that the information was material information. The President of GMI, whose deposition was read at trial, himself treated the information as material inside information, testifying that he had declined to furnish a Lehman Brothers' research analyst with the information because it was not publicly available.*fn4 Almost immediately following the receipt by Lehman Brothers of the information concerning the level of the REIT's problem loans, the Lehman Brothers' analyst receiving the information prepared a "Research Wire" labeled, "Not for distribution outside of Lehman Brothers," devoted exclusively to reporting the information received and to an analysis of its significance in terms of the REIT's loss reserves, earnings and anticipated dividend levels. A second contact by the research analyst with another representative of GMI a week later, which, the jury could have found, produced additional information concerning the REIT's problem loans, was recorded by the analyst in an "REIT contact report." According to the testimony, this report, which on its face indicated that GMI management was the source of the information discussed, was circulated to customers of Lehman Brothers including, the jury could infer, the defendant pension fund. Again, the report explicitly analyzed the effect of the information with regard to problem loans on the REIT's anticipated earnings and dividend levels noting that "Audited earnings for the fiscal year ended February 28, 1974 are expected to be reported between 3/22/74 and 3/27/74." (Emphasis in original.)
Despite the obvious importance attributed to the information concerning the increase in GMI's problem loans by both GMI and Lehman Brothers, the court below concluded that the jury could not rationally find that the information was material. A principal basis for this conclusion appears to have been the fact that, according to Lehman Brothers' memoranda introduced during the plaintiffs' case, it was the view, first expressed by the brokerage firm as that of the brokerage firm itself arrived at after discussions with management and later simply as that of management, that no loss of principal was anticipated on any of the REIT's problem loans. Given this conclusion, the court below reasoned, no increase in loss reserve to guard against loss of principal was necessary and no decrease in dividends could be foreseen. Since no substantial change in the dividend level was anticipated, the inside information was not "reasonably certain to have a substantial effect on the market of price of the security," a test of materiality taken by the court below from S.E.C. v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968) (en banc), Cert. denied sub nom. Coates v. S.E.C., 394 U.S. 976, 89 S. Ct. 1454, 22 L. Ed. 2d 756 (1969), and the "anticipated magnitude of the event in the light of the totality of the ...