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August 21, 1985

In re WARNER COMMUNICATIONS Securities Litigation

The opinion of the court was delivered by: KEENAN


JOHN F. KEENAN, United States District Judge:

 The parties to this action seek an order, pursuant to Rule 23 (e) of the Federal Rules of Civil Procedure ("FRCP"), approving their proposed settlement of this class action. In addition, plaintiffs' counsel have applied for an order awarding them attorneys' fees for services rendered and reimbursement of expenses. For the reasons stated below, the Court approves the proposed settlement and grants plaintiffs' counsels' application for the award of fees and expenses.


 This action is a consolidation of 19 actions, most of which were begun in December 1982. Eighteen were brought on behalf of persons who, during the period from March 3, 1982 through December 8, 1982, purchased Warner Communications Inc. ("Warner") common stock, common stock purchase warrants, call options on Warner shares, or who sold put options covering Warner shares. In addition, one plaintiff sued derivatively on behalf of Warner. *fn1"

 The Consolidated Amended Complaint ("Complaint"), filed in July, 1983, alleges that certain defendants violated Section 10 (b) of the Securities Exchange Act of 1934 ("the 1934 Act"), Rule 10b-5 promulgated thereunder, and the common law by engaging in a common scheme or conspiracy, the purpose of which was to cause the market prices of Warner securities to be artifically inflated during the class period. Defendants allegedly issued a series of false and misleading public statements that led the investing public to believe that Warner's operations would continue their unbroken pattern of dramatic growth and increasing profits and that Warner's competitive position would be maintained or improved. In particular, the Complaint alleges that materially misleading information was disseminated about the performance of Warner's former subsidiary, Atari, Inc. ("Atari"), which manufactured and marketed home video games and cartridges as well as coin-operated video arcade games. Warner allegedly stated that Atari's spectacular and highly profitable growth during 1981 was expected to continue in 1982. Misleading statements were also alleged with respect to the operations of two other Warner divisions, Warner Amex Cable Communications ("Warner Cable") and Knickerbocker Toy Company, Inc. ("Knickerbocker").

 Plaintiffs alleged that defendants failed to disclose during the class period that Atari's market share in the home video game market was sharply diminished due to increasing competition, that its growth rate was slowing, that its products were no longer state of the art, that its rate of sales and profitability were declining, that its home video game segment was experiencing a serious sales slowdown, particularly in sales of game cartridges, and that it was experiencing cancellations in orders for its products at unprecedented rates. Plaintiffs further alleged that defendants had no reasonable basis for making statements during the class period that Warner would achieve record 1982 profits of between $5.00 and $5.75 per share. Plaintiffs contended further in their Complaint that certain individual defendants were selling large portions of their Warner holdings while in possession of this material adverse information about Warner which had not been publicly disclosed.

 On December 8, 1982, the true status of Warner's operations and financial position became public. Warner announced that Atari's sales were disappointing, and that cancellations of sales of cartridges and a write-off exceeding $20 million in connection with Warner's Knickerbocker unit would result in Warner's fourth quarter earnings being approximately 50% less than they had been in the prior comparable period and its 1982 fiscal results would be considerably less than previously represented to the investing public. The price of Warner common stock dropped, falling over 16 points the next day. Other Warner securities were similarly affected.

 Defendants in this action include Warner, Atari and certain present and former officers and directors of Warner and Atari. In essence, all the defendants are charged with a classic fraud-on-the-market and the individual defendants are charged with insider trading. They deny the allegations of the Complaint.

 After lengthy negotiations, the parties stipulated to certification of the alleged class, without waiver of defendants' rights to later challenge that certification, and this Court so ordered that stipulation on February 17, 1984. The class as certified consisted of all persons or entities who, during the period from March 3, 1982 to and including December 8, 1982: (i) purchased Warner Common stock, (ii) purchased warrants to purchase Warner common stock, (iii) purchased call options to acquire Warner common stock that remained unexpired on December 8, 1982, or (iv) sold put options to dispose of Warner common stock which were open positions as to them on December 8, 1982. Pursuant to this Court's Order, notice of the pendency of these class actions was subsequently mailed to approximately 100,000 potential class members, and was published in summary form in both The Wall Street Journal and The New York Times.

 Extensive discovery was had in this case. During the second half of 1983, plaintiffs reviewed over 80,000 pages of documents produced, pursuant to discovery demands, by defendants and numerous third parties. Plaintiffs also reviewed depositions of Warner and Atari officials taken during the course of a Securities and Exchange Commission ("SEC") investigation. Only after substantial discovery was completed did settlement negotiations commence. Those negotiations ultimately yielded the settlement proposal described below.


 A. Settlement Proposal

 The proposed settlement provides that defendants shall pay $17,250,000.00, plus accrued simple interest at the rate of 8% per annum from January 1, 1985. The settlement fund shall also include $290,000.00, plus accrued interest, which represents the amounts paid by defendants Groth and Kassar, officials of Atari, to the SEC as disgorgement of their profits on insider sales. The settlement agreement also requires defendant Warner to bear the cost of providing notice to the class members and settlement administration, which represents a benefit to the class of at least $200,000.00. The total value of the settlement, as of July 23, 1985, the date of the settlement hearing, is approximately $18,600,000.00.

 The particulars of the complex method of allocation of the settlement fund among the class members need not be explained at length in this opinion. Suffice it to say, however, that the proposal recognizes that the potential for recovery varies among class members depending on whether they continued to hold their Warner securities at the end of the class period and when during the class period they effected their Warner securities transactions. Discovery indicated that more information was available to defendants concerning Warner's and Atari's earnings prospects as 1982 drew to a close than was available in earlier periods. For this reason, class members purchasing between March 3 and August 1, 1982 can expect recovery of up to 5% of their claims. Purchasers during the third and early fourth quarters, from August 2 through November 4, will receive up to 25% of their claims. Late 1982 purchasers -- those who bought between November 5 and December 8, when more information about 1982 prospects was available -- will receive up to 75% of their claims.

 B. Judicial Review of the Settlement Proposal

 In deciding whether to approve this settlement proposal, the court starts from the familiar axiom that a bad settlement is almost always better than a good trial. This case is an exception to that rule only to the extent the settlement is a very good one. There is little doubt that the law favors settlements, Jones v. Amalgamated Warbasse Houses, Inc., 97 F.R.D. 355, 358 (E.D.N.Y. 1982), aff'd, 721 F.2d 881 (2d Cir. 1983), cert. denied, 466 U.S. 944, 104 S. Ct. 1929, 80 L. Ed. 2d 474 (1984), particularly of class action suits, Weinberger v. Kendrick, 698 F.2d 61, 73 (2d Cir. 1982), cert. denied, 464 U.S. 818, 104 S. Ct. 77, 78 L. Ed. 2d 89 (1983). To withstand judicial scrutiny, the settlement need only be "fair, reasonable and adequate." Weinberger, 698 F.2d at 73; West Virginia v. Chas. Pfizer & Co., 440 F.2d 1079, 1085 (2d Cir.), cert. denied sub nom. Cotler Drugs, Inc. v. Chas. Pfizer & Co., 404 U.S. 871, 30 L. Ed. 2d 115, 92 S. Ct. 81 (1971). In making this determination, the Court's role is to compare the terms of the compromise with the likely rewards of litigation. Protective Committee for Independent Stockholders of TMT Trailer Ferry, Inc. v. Anderson, 390 U.S. 414, 424-25, 20 L. Ed. 2d 1, 88 S. Ct. 1157 (1968); Weinberger, 698 F.2d at 73; In Re "Agent Orange" Product Liability Litigation, 597 F. Supp. 740, 762 (E.D.N.Y. 1984); Kaye v. Fast Food Operators, Inc., 99 F.R.D. 161, 163 (S.D.N.Y. 1983). In City of Detroit v. Grinnell Corp., 495 F.2d 448, 463 (2d Cir. 1974), the Second Circuit provided a nonexhaustive list of factors to consider in reviewing a settlement proposal:

(1) the complexity, expense and likely duration of the litigation. . .; (2) the reaction of the class to the settlement. . .; (3) the stage of the proceedings and the amount of discovery completed. . .; (4) the risks of establishing liability. . .; (5) the risks of establishing damages. . .; (6) the risks of maintaining the class action through the trial. . .; (7) the ability of the defendants to withstand a greater judgment. . .; (8) the range of reasonableness of the settlement fund in light of the best possible recovery. . .; [and] (9) the range of reasonableness of the settlement fund to a possible recovery in light of all the attendant risks of litigation. . . . (Citations omitted).

 Accord Malchman v. Davis, 706 F.2d 426, 433-34 (2d Cir. 1983). It is also appropriate to examine the negotiating process that gave rise to the settlement. Weinberger, 698 F.2d at 74. The proper inquiry in this regard is whether the settlement was achieved through "arm's length negotiations" by counsel who have "the experience and ability . . . necessary to effective representation of the class's interests." Id.

 1. Risk In Establishing Liability

 Plaintiffs' principal claim against the defendants is that they made material misstatements, TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 445, 48 L. Ed. 2d 757, 96 S. Ct. 2126 (1976), with actual knowledge of falsity or in reckless disregard for the truth (i.e. scienter), Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976), in violation of § 10 (b) of the 1934 Act, and Rule 10b-5 promulgated thereunder. Plaintiffs, therefore, would have the burden of proving that defendants not only possessed information regarding the performance of Atari which, if publicly disseminated, would have materially affected the price of the stock, but also that defendants withheld that information from the investing public either with actual intent to deceive, manipulate or defraud or that defendants recklessly disregarded the facts and their consequences.

 Plaintiffs' major claims are that beginning in March 1982 and throughout the class period ending December 8, 1982, adverse trends began to develop concerning the business of Atari which defendants should have disclosed. Those adverse developments included: an increasing rate of cancellations of orders for video computer hardware and cartridges; accumulation of excess inventories of those items on Warner's and on retailers' shelves due to declining demand for the product in the marketplace; increasing competition in the home video market causing saturation of the market, cutting into the demand for Atari's products and at the same time causing Warner to experience a declining profit margin because of the necessity to cut prices, particularly of cartridges; and the lack of any significant "hit" cartridges, other than "Pac Man," during the class period. Discovery indicated that these problems became more severe and more obvious over time.

 Plaintiffs would have attempted to meet their burden of proving scienter, as required under Rule 10b-5, principally by showing that (i) at least 13 of 16 individual defendants sold significant portions of their personal holdings of Warner stock at the high prices prevailing during the class period and profited handsomely before the adverse information was disclosed, and (ii) Warner decided during the third quarter of fiscal 1982 to expand the third quarter from thirteen to fourteen weeks, allowing Warner to meet its forecasts for the quarter.

 Defendants, on the other hand, would argue that they reasonably believed that their class period statements were accurate and that the growth experienced by Atari in 1981 would continue. First quarter 1982 results were basically on target with their projections and Pac-Man became a national phenomenon and Atari's largest selling cartridge. The cancellations of orders and inventory build-up occurred gradually and could not be viewed as a trend until months after it began. Both the second and third quarter results for Atari and Warner significantly surpassed 1981's record totals. Since the fourth quarter, encompassing Thanksgiving and Christmas, was historically Atari's strongest quarter at retail, Warner had reason to believe that its announced goals would be met by significant fourth quarter results. This belief was further strengthened by Atari's efforts to develop new cartridges for fourth quarter release based upon the popular movies "E.T." and "Raiders of the Lost Ark." Defendants would also present evidence showing that during 1982, in August and again in October, they lowered their sales and revenue projections, taking into account cancellations of orders and a slower rate of new orders. Therefore, they would argue, since their statements about growth were consistent with these revised downward projections, there was no need to disclose individual negative factors like cancellations. Other positive factors balanced out the negatives and were taken into consideration in the internal budgets they prepared which supplied the basis for their public reports. Defendants would point to the fact that in fiscal 1982, Warner actually experienced an 11% increase in earnings per share over their record year of 1981. Defendants would argue further that the market had simply overreacted to their December 8 press release containing a revised earnings estimate.

 With respect to the issue of scienter, each of the 16 individual defendants would have presented different personal financial or tax reasons to justify their sale of Warner securities during the class period, reasons alleged to be completely independent of Warner's financial condition. At deposition, defendant Ross, for example, explained that his sale was made pursuant to an overall tax plan that had been created by a financial adviser long before the class period. Defendant Ross testified that he had decided in late 1981 to sell a large enough number of shares of his Warner stock to be able to realize $18,000,000, thus allowing him to reduce his liabilities resulting from his exercise of a class of Warner stock options which were expiring in early 1982. Ross testified that all Warner officers and directors had similar tax problems because the tax law held that the exercise of the expiring options resulted in taxable income to the option-holder even though the option-holder received no cash from the exercise and indeed had to pay the exercise price. The options nevertheless had to be exercised or they would have expired. In order to pay the taxes, Ross and others sold their Warner stock. Even though Ross had decided in late 1981 to sell the stocks to pay these liabilities, he determined that he would not actually sell the stock until his intention to sell was disclosed in the proxy statement for the May 28, 1982 Annual Meeting and until he had obtained further options under a new stock option plan that allowed him to maintain his relative equity position in Warner.

 Defendants would assert that the addition of a week to the third quarter was a decision they made without consideration of the financial results that were reported. According to deposition testimony, Warner was operating on a 52-week year and every seven years an additional week had to be added to a quarter, to keep close to the calendar year end. This week fell in 1982 and the decision was made to add it to the third quarter, allegedly independent of any shortfalls at Atari.

 Defendants would attempt to characterize the plaintiffs' case as one that does not challenge the actual financials of Warner during the class period, but only alleges that Warner made faulty projections or prognostications or expressed faulty opinions about future performance. Defendants would argue, with some support, that such predictions are not actionable under § 10 (b) and Rule 10b-5 if defendants had a reasonable basis upon which to make such statements in view of the facts known within the company. See, e.g., Marx v. Computer Sciences Corporation, 507 F.2d 485, 489-90 (9th Cir. 1974); Myzel v. Fields, 386 F.2d 718, 734 (8th Cir. 1967), cert. denied, 390 U.S. 951, 19 L. Ed. 2d 1143, 88 S. Ct. 1043 (1968); REA Express, Inc. v. Interway Corp., 410 F. Supp. 192, 197-98 (S.D.N.Y.), rev'd on other grounds, 538 F.2d 953 (2d Cir. 1976). Plaintiffs would argue that Warner's and Atari's negative trends were of a long-standing nature, and that their internal budgets failed to adequately account for the cancellations, inventory accumulations and reduced rate of orders. Warner, however, could rely on its own internal budgets, which were revised downward several times during the class period, Atari's record sales around Thanksgiving time and the suddenness of the business' deterioration immediately after Thanksgiving. It is clear that whether Warner had a reasonable basis for its public statements would have been the subject of a lengthy and hotly contested evidentiary dispute.

 Plaintiffs undoubtedly thought they could win this case, though they readily concede that defendants were not without evidence to support their defense. See West Virginia v. Chas. Pfizer & Co., 314 F. Supp. 710, 743-44 (S.D.N.Y. 1970) ("It is known from past experience that no matter how confident one may be of the outcome of litigation, such confidence is often misplaced"), aff'd, 440 F.2d 1079 (2d Cir.), cert. denied, 404 U.S. 871, 92 S. Ct. 81, 30 L. Ed. 2d 115 (1971). Plaintiffs further admit that discovery revealed "no smoking gun." (Plaintiffs' Memorandum in Support of the Proposed Settlement at 44). Indeed, it is evident that, had this case gone to trial, there exists a substantial risk that plaintiffs would have failed to successfully establish defendants' liability.

 This risk is further borne out by the SEC's action with respect to the underlying facts of this case. Shortly after the instant action was commenced in December 1982, the SEC initiated its own investigation of Warner, Atari and certain of their important officers and directors. The SEC's investigation focused primarily on insider trading, rather than the broader open market fraud allegations of this litigation. The SEC conducted an extensive review of the corporate defendants' records and several depositions of their top officials. At what appeared to be the conclusion of the SEC's investigation, the SEC compelled Atari's top officers, defendants Kassar and Groth, to disgorge profits realized from the sale of Warner stock only during the period from November 17 to December 8, the date of Warner's announcement of Atari's decline. *fn2" The SEC took no action against any Warner official. Surely, the limited action taken by the SEC, after a comprehensive investigation, can properly be considered evidence of plaintiffs' risk that they may not be able to establish defendants' liability, particularly on the insider trading claims.

 A further risk for plaintiffs exists in the unsettled state of the law as to whether options purchasers or sellers have standing to maintain a claim under § 10 (b) of the 1934 Act. Courts outside the Second Circuit have split on this issue. Compare In re Digital Equipment Securities Litigation, 601 F. Supp. 311, 315 (D. Mass 1984) (upholding such claims) and Backman v. Polaroid Corp., 540 F. Supp. 667, 671 (D. Mass 1982) (same) with Laventhall v. General Dynamics Corp., 704 F.2d 407, 414 (8th Cir.) (dismissing claim), cert. denied, 464 U.S. 846, 104 S. Ct. 150, 78 L. Ed. 2d 140 (1983) and In re McDonnell Douglas Corp. Securities Litigation, 567 F. Supp. 126, 127 (E.D. Mo. 1983) (same). In fact, the cases decided in this Court, while factually distinguishable, can be read to support contrary legal positions. Compare Lloyd v. Industrial Bio-Test Laboratories, Inc., 454 F. Supp. 807, 811 (S.D.N.Y. 1978) (option purchasers granted standing to sue) with Desimone v. Industrial Bio-Test Laboratories, Inc., 80 F.R.D. 112, 113 (S.D.N.Y. 1978) (class of options purchasers was not certified because the option class was not carefully defined).

 In view of the factual disputes surrounding the issue of defendants' liability, the outcome of the SEC's investigation into the affair and the unsettled legal issues involved, plaintiffs certainly bear a substantial risk of losing this case at trial.

 2. Risk in Establishing Causation/Damages

 Even if plaintiffs are successful in establishing that defendants intentionally or recklessly misrepresented Warner's financial condition, it is yet another obstacle for plaintiffs to prove that defendants' misrepresentations caused the damages allegedly sustained by plaintiffs.

 The Second Circuit employs the "out-of-pocket" damage measure in Rule 10b-5 cases. Levine v. Seilon, Inc., 439 F.2d 328, 334 (2d Cir. 1971); Bonime v. Doyle, 416 F. Supp. 1372, 1384 (S.D.N.Y. 1976), aff'd mem., 556 F.2d 554 (2d Cir.), cert. denied, 434 U.S. 924, 98 S. Ct. 401, 54 L. Ed. 2d 281 (1977); Quintel Corp. N.V. v. Citibank, N.A., 596 F. Supp. 797, 802 (S.D.N.Y. 1984); Freschi v. Grand Coal Venture, 588 F. Supp. 1257, 1259 (S.D.N.Y. 1984). Under this measure, a defrauded buyer may recover the difference between the price paid for the stock and the "fair value" of the stock (value absent the fraud), as of the date of his or her purchase. See Sirota v. Solitron Devices Inc., 673 F.2d 566, 577-78 (2d Cir.), cert. denied, 459 U.S. 838, 74 L. Ed. 2d 80, 103 S. Ct. 86 (1982).

 Plaintiffs may argue that the "fair value" of the stock should be drawn from its market price following revelation of the fraudulently withheld material. See Harris v. American Invest. Co., 523 F.2d 220, 226-27 (8th Cir. 1975); cert. denied, 423 U.S. 1054, 46 L. Ed. 2d 643, 96 S. Ct. 784 (1976); In re Brown Co. Sec. Litigation, 355 F. Supp. 574, 588 (S.D.N.Y. 1973); SEC v. Texas Gulf Sulphur Co., 331 F. Supp. 671, 672 (S.D.N.Y. 1971). Defendants will likely counter that the post-disclosure market price of the stock has been affected by factors unrelated to the disclosure. See Sirota, 673 F.2d at 577; Blackie v. Barrack, 524 F.2d 891, 909 n.25 (9th Cir. 1975), cert. denied, 429 U.S. 816, 50 L. Ed. 2d 75, 97 S. Ct. 57 (1976); Burger v. CPC Int'l, Inc., 76 F.R.D. 183, 187-88 (S.D.N.Y. 1977); Bonime, 416 F. Supp. at 1384. Indeed, defendants bear no responsibility for the impact of so-called nonactionable factors, such as general market conditions. Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 49 n.22 (2d Cir.), cert. denied, 439 U.S. 1039, 58 L. Ed. 2d 698, 99 S. Ct. 642 (1978). In this case, during most of the class period, Warner stock was dropping in price even though the fraud, designed to inflate the price, was allegedly in operation. This price decline, from about $55 per share in August 1982 to $37 per share a month later, followed trends throughout the industry. In the next three months, through early December, prices of Warner stock, and the stock of its competitiors, even in the face of negative publicity, rose dramatically. While Warner stock fell dramatically after the industry also fell abruptly during this time.

 Thus, plaintiffs are faced with a situation where during that part of the class period in which a stronger case can be made for liability, the market price of Warner and similar stocks was fluctuating dramatically. At one point, the price may have far exceeded fair value because of frenzied buying, not fraud. Weeks later, coincidental to revelation, the price may have been lower than fair value due to panic selling and a general downturn in the market. Under these circumstances, the degree to which the post-revelation decline is attributable to disclosure, and to what extent the decline was the result of nonactionable market and industry trends is difficult to ascertain. A market analyst consulting expert retained by plaintiffs' counsel concluded that by employing a conservative, but ...

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