The opinion of the court was delivered by: JONES
UNITED STATES DISTRICT JUDGE
This consolidated class action arises from allegations that a trader at defendant Kidder, Peabody & Co., Inc. ("Kidder") engaged in an ongoing scheme from late 1991 until April 1994 to generate false profits through the use of phantom trades. At the time of the alleged scheme, Kidder was a wholly-owned subsidiary of General Electric Company ("GE"). Following disclosure of the scheme, plaintiffs, shareholders of GE who purchased GE common stock between February 26, 1993, and April 15, 1994, commenced this action. Plaintiffs allege that Kidder, its holding company, defendant Kidder, Peabody Group, Inc. ("Kidder Group"), and four employees of Kidder, including the trader directly responsible for generating the false profits, violated the Securities Exchange Act of 1934 by making or causing to be made public statements that incorporated the false profits.
Plaintiffs' complaint originally pled twenty-four allegedly false or misleading public statements. Of these, thirteen had been made by GE in public filings, reports and press releases, five had been made by securities analysts, and one had been made by former New York City Mayor David Dinkins. The remaining five statements had been made directly by Kidder or by a Kidder employee.
On October 4, 1995, the Court denied defendants' motions to dismiss the complaint. In re Kidder Peabody Sec. Litig., 1995 U.S. Dist. LEXIS 14481, No. 94 Civ. 3954, 1995 WL 590624 (S.D.N.Y. Oct. 4, 1995) ("Kidder I "). As part of that decision, however, the Court agreed with defendants that they could not be held liable for statements attributed to GE or to other third parties. Id. at *4. Accordingly, the Court dismissed the claims based on those statements, leaving in the case only the five statements directly attributable to Kidder or Kidder's employees. Id.
Currently pending are defendants' motions for summary judgment, pursuant to Fed. R. Civ. P. 56. Defendants Kidder, Kidder Group, Michael A. Carpenter ("Carpenter"), Richard W. O'Donnell ("O'Donnell"), Edward A. Cerullo ("Cerullo"), and Orlando Joseph Jett ("Jett") join in arguing for summary judgment on the ground that plaintiffs cannot prove, as a matter of law, that any of the allegedly false statements were material. All of the defendants, except for Jett, also argue for summary judgment on the ground that plaintiffs cannot prove, as a matter of law, that they acted with the requisite scienter. In addition, Cerullo argues that he is entitled to summary judgment because plaintiffs cannot prove that he was personally responsible for any of the allegedly false statements or that he owed a duty to GE's shareholders.
Also pending is plaintiffs' application to reinstate the thirteen statements attributed to GE and the five statements attributed to securities analysts, which previously were dismissed by the Court. Plaintiffs argue that defendants should be held liable for these statements because defendants were directly responsible for making them, using GE and the analysts as conduits for materially false information.
The following facts are not in dispute unless otherwise noted.
I. Kidder's Organizational Structure and Relationship to GE
At all relevant times, Kidder was a registered securities broker-dealer and full-service investment bank, and a wholly owned subsidiary of Kidder Group, a holding company for several related businesses. Kidder's businesses included securities underwriting, sales and trading of equity and fixed income securities, corporate finance advisory services, and retail brokerage and asset management.
During the class period, Carpenter served as Kidder's Chairman of the Board of Directors and Chief Executive Officer. Below Carpenter was O'Donnell, who served as Kidder's Chief Financial and Administrative Officer. O'Donnell's responsibilities included overseeing Kidder's operations and its audit and credit functions.
Kidder's relationship with GE began in April 1986, when GE purchased Kidder for $ 602 million. From then until late 1994,
Kidder, through Kidder Group, was a wholly-owned subsidiary of GE Capital Services ("GECS"). GECS, in turn, was a wholly-owned subsidiary of GE, functioning as GE's financial services unit.
GE is engaged in a wide variety of businesses including lighting, appliances, aircraft engines, broadcasting (through NBC), plastics, medical equipment, and power generation. Unlike Kidder, Kidder Group, or GECS, GE is a publicly held company, with its common stock traded on the New York Stock Exchange ("NYSE"). Consistent with its duties as a publicly held company, and pursuant to rules promulgated by the Securities Exchange Commission ("SEC"), GE makes regular public disclosure of its financial statements. During the relevant time period, GE's statements included financial information related to Kidder.
During the class period, Kidder's most dominant business unit was the Fixed Income Division, which was headed by Cerullo.
According to plaintiffs, this division accounted for the great majority of Kidder's net income and approximately 90% of the book value of Kidder's assets.
The Fixed Income Division consisted of twelve trading desks, including the Government Securities Desk. In July 1991, Jett was hired by Kidder to trade at this desk. It was from this desk that Kidder's false profits originated over the next two and a half years.
II. Trading of Treasury Bonds
Kidder's Government Securities Desk traded in bonds issued by the United States Treasury. As traded on the secondary market, each bond consists of separate components, representing fixed interest and principal payments. Individually, these components are known as "STRIPS," for "Separate Trading of Registered Interest and Principal of Securities." Collectively, these STRIPS constitute a completed bond.
Due to the time value of money, in trading with consumers, a STRIPS security will sell for less than its final payment value. This is because the present value of the right to receive a future payment is less than the value of receiving that payment immediately. Generally, the greater the length of time between purchase date and final payment date, the greater the gap between current price and final value. The converse is also true: As the payment date approaches the price of a STRIPS security will increase, until payment date, when the two values converge.
Purchasers and dealers of STRIPS seek to profit on shifts in interest rates and demand that occur between the sale date of a STRIPS security and its payment date. Dealers also can make profits through "arbitrage," exploiting small, temporary price discrepancies between bonds and the component STRIPS. Thus, if the demand for individual STRIPS on any given day is higher than their current market value as a fully reconstituted bond, a dealer may be able to make a profit by stripping a bond and selling the individual components.
To facilitate the trading of government bonds, the Federal Reserve Board ("Federal Reserve"), acting as agent for the United States Treasury, stands ready at any time to exchange a bond for its individual STRIPS, or vice versa. The exchange of a full set of STRIPS for a bond is known as a "reconstitution" or "recon." The opposite exchange, of a bond for its individual STRIPS, is known as a "strip."
Unlike the sale of STRIPS or bonds to consumers, the exchange of STRIPS for bonds (or bonds for STRIPS) between a broker-dealer and the Federal Reserve has no economic significance. Such an exchange is merely a non-cash trade of economically equivalent securities, much like the exchange of one $ 100 bill for five $ 20 bills. Only the Federal Reserve can execute a strip or recon exchange and the Federal Reserve does not arrange, agree to, or confirm such exchanges in advance.
III. Jett Begins to Trade
Although Jett had never traded in government securities, Kidder hired him, according to Jett, to reestablish profitability on the Government Securities Desk. Kidder expected Jett to make profits in part by dealing in STRIPS with customers and through opportunities for arbitrage. According to Melvin Mullin ("Mullin")
, Jett's first supervisor at Kidder, when Jett started in 1991 strip and recon arbitrage with customers could result in "profit opportunities in the range of $ 2000 per million." Such opportunities arose from "doing trades with customers to capture the price differences."
Jett's initial performance at Kidder was "fairly slow," according to Mullin. In August 1991, Jett lost money; the following two months he made only small profits of $ 229,000 and $ 275,000. These profits were far less than the $ 1 million in profits per month that Cerullo and Mullin expected Jett to generate from his trading activities. As a result, at the end of October, Kidder categorized Jett's performance as "Improvement Desirable," giving Jett the second lowest rating on Kidder's five-point performance scale.
Towards the end of 1991, however, Jett's performance appeared to turn around, with reported profits of $ 500,000 in November. After a dip in December, Jett exceeded his $ 1 million target for the first time with reported profits of almost $ 1.2 million in January 1992. His reported profits continued to grow throughout 1992, reaching a high of $ 4.86 million in July. In total, Jett reported profits of $ 32.481 million for 1992. For these efforts, Jett was awarded a year-end performance bonus of $ 2 million and promoted to Senior Vice President.
In fact, Jett's trading had resulted in actual losses of $ 7.943 million.
These real losses had been cloaked by the reporting of $ 40.424 million in false profits. The source of these false profits was "forward recons" with the Federal Reserve that Jett had begun to enter in November 1991.
A "forward recon" is simply a reconstitution entered for settlement more than one business day forward; in other words, a promise on day one to reconstitute a bond at some time in the future. As explained above, a "recon"--where a trader exchanges a complete set of STRIPS for a bond of equivalent value--has no economic impact, and involves no exchange of capital. Likewise, a forward recon has no economic impact; it is merely a promise to exchange economically equivalent securities in the future.
Nevertheless, due to the way Kidder's computerized trading and accounting systems had been set up, when a trader such as Jett entered a forward recon, the computer would treat the transaction as an immediate sale of STRIPS securities. This would result in the appearance of a profit, because the present "sale" price of the STRIPS would be lower than its ultimate payment value. Put differently, Kidder's computer would take the difference between the current price of the STRIPS and the forward price of the STRIPS and record that difference as an immediate profit. The larger the bond to be reconstituted or the farther forward the settlement date, the larger the apparent profit. In reality, this profit was illusory and there was no legitimate purpose or economic reality behind the entry of forward recons into the computer. At no point was there any exchange or receipt of capital.
Moreover, for the same reason the computer would generate a false profit on day one, as the settlement date for the recon approached, the computer would generate a corresponding false loss. In other words, as the current value of the STRIPS converged with its payment value, the apparent profit decreased, generating an offsetting false loss. By settlement date, the original false profit would be eliminated. As a result, to continue the illusion of profits, a trader would have to continue to enter more and more forward recons, with more and more distant settlement dates.
And this is just what Jett began to do. After entering 142 recons and strips in 1991, Jett entered 1039 for 1992. That number grew to 2398 in 1993, and to 1997 for the first quarter of 1994. Jett also started to enter forward recons with increasingly distant settlement dates. Prior to November 1992, the longest settlement date Jett could enter on Kidder's computers was five business days. After November, however, a change in Kidder's computer entry options allowed Jett to enter any future settlement date he wanted. This enhanced Jett's ability to foster the illusion of profits, with Jett entering forward recons with settlement dates as much as 203 days forward; twelve times he entered forward recons with settlement dates of more than 115 days forward.
By using forward recons, Jett's reported profits in 1993 grew to over $ 10 million for every month starting with March. In September alone, Jett reported profits of over $ 21 million. In total, for 1993, Jett reported profits of $ 150.654 million. For his efforts, Jett was named Kidder Man of the Year and awarded a year-end performance bonus of over $ 9 million.
In fact, Jett's use of forward recons in 1993 had resulted in the reporting of $ 198.182 million in false profits. This had masked an actual trading loss by Jett of $ 47.528 million.
The use of forward recons continued into 1994, with Jett reporting profits of $ 35.813 million for January, $ 30.094 million for February, and $ 14.193 million for March. Again, these reported profits were illusory, with Jett's forward recons generating $ 99.837 million of false profits for the first three months of 1994. This masked actual trading losses of $ 19.737 million.
In total, by the end of March 1994, Jett's trading had generated $ 338.698 million in false profits. He had not reported a loss for any month since December 1991 and had reported at least a $ 10 million profit for every month in the preceding year. In reality, Jett's phantom trades had masked $ 74.676 million in losses.
To put Jett's reported profits in perspective, prior to Jett's employment, according to plaintiffs, the previous record at Kidder for profits on STRIPS trading was approximately $ 15 million for an entire year. Jett had exceeded that mark within just one month four times--in March and September 1993 and in January and February 1994. On one transaction alone--a forward recon entered on November 17, 1992, for a $ 200 million bond scheduled to settle on June 8, 1993--Jett generated an apparent profit of $ 12.9 million. On another--a January 21, 1994 forward recon for a $ 800 million bond scheduled to settle on April 25, 1994--Jett generated an apparent profit of $ 24.2 million. Since starting to enter forward recons Jett had never reported a losing month.
IV. Effect of the False Profits on Kidder's Reported Earnings
In the five years preceding Jett's hiring, Kidder reported net operating losses in at least three years.
In 1991, however, Kidder reported an operating profit of $ 119 million. The following years, Kidder's reported profits increased to $ 300 million in 1992 and $ 439 million in 1993.
In reality, these figures incorporated the false profits generated from Jett's trading activities. Thus, in 1992, Kidder's profits were inflated by approximately 13.5%. In 1993, Kidder's profits were inflated by approximately 45%. And, as mentioned above, these profits were reported in public disclosures made by GE.
Jett's trading at Kidder finally came to end in April 1994. For reasons in dispute, on or about April 14, 1994, officials at Kidder notified regulators and GE that they had confirmed the existence of up to $ 350 million in false profits. On Sunday, April 17, 1994, GE and Kidder issued separate press releases disclosing the false profits. GE announced that it was taking a one-time, non-cash charge of $ 210 million ($ 350 million pre-tax) against its first quarter earnings. Kidder did the same. Kidder further announced that Jett had been fired.
The next day, Monday, April 18, GE's stock closed at $ 94.875, with a trading volume of 1.8 million shares. This was down $ 1.875, or 1.94%, from the stock's closing price of $ 96.75 on Friday, April 15. According to plaintiffs' calculation, as a result of this decrease, by week's end GE had suffered a market capitalization loss of approximately $ 1.6 billion.
In the months that followed, Kidder's legal department conducted a preliminary inquiry. Subsequently, the SEC commenced an investigation that led to enforcement proceedings against Cerullo, Mullin and Jett.
The United States Attorney's Office and the NYSE also conducted separate investigations.
In June 1994, Carpenter resigned from Kidder. One month later, Cerullo resigned as well. O'Donnell left his position in January 1995.
On or about October 7, 1994, plaintiffs filed their Consolidated Amended Class Action Complaint, seeking total damages of more than $ 228 million. In Count I, plaintiffs allege that all of the defendants violated Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and SEC Rule 10b-5 promulgated thereunder. In Count II, plaintiffs allege that all of the defendants except for Kidder violated Section 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. § 78t(a), by acting as "controlling persons."
The Court's discussion begins with plaintiffs' application to reinstate the thirteen statements attributed to GE and the five statements attributed to securities analysts, which previously were dismissed by the Court. The Court then will turn to defendants' motions for summary judgment.
I. Plaintiffs' Application
As explained above, while denying defendants' motions to dismiss the complaint, the Court agreed with defendants that they could not be held liable for statements attributed to GE or to securities analysts. Kidder I, 1995 U.S. Dist. LEXIS 14481, 1995 WL ...