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FOGARAZZO v. LEHMAN BROTHERS

May 21, 2004.

LAWRENCE FOGARAZZO and CAROLYN FOGARAZZO, Joint Tenants With Rights of Survivorship, STEPHEN L. HOPKINS, and DON ENGEL on behalf of themselves, and all others similarly situated, Plaintiffs, -against- LEHMAN BROTHERS, INC., GOLDMAN SACHS & CO., and MORGAN STANLEY & CO., INC., Defendants


The opinion of the court was delivered by: SHIRA SCHEINDLIN, District Judge

OPINION AND ORDER

I. INTRODUCTION

  Plaintiffs, investors in RSL Communications, Inc., allege that Lehman Brothers, Inc., Goldman Sachs & Co., and Morgan Stanley & Co., Inc. (the "Banks") issued false and misleading research reports pertaining to RSL. Specifically, plaintiffs allege that the reports were fraudulently optimistic due to conflicts of interest between the research and investment banking departments of the defendant Banks. The Banks, having entered into a settlement with state and federal regulators, do not contest (at this point) the existence of the conflicts or that the reports were false. Rather, they argue that because plaintiffs have not alleged a causal connection between the alleged fraud and the subsequent decline of RSL stock, the complaint must be dismissed. In addition, the Banks contend that because analyst conflicts of interest have been well-publicized for almost a decade, plaintiffs' claims are time-barred.

 II. THE COMPLAINT

  The following allegations, drawn from plaintiffs' complaint, are presumed to be true for purposes of this motion.

  A. Parties

  Plaintiffs Lawrence and Carolyn Fogarazzo, Stephen L. Hopkins, and Don Engel filed this suit on behalf of all investors who purchased shares of RSL common stock between April 30, 1999, and December 29, 2000.*fn1 By Order dated September 24, 2003, 1 appointed the RSL Communications Shareholders Group — comprising the Fogarazzos, Hopkins, and Engel — as lead plaintiffs under the Private Securities Litigation Reform Act of 1995.*fn2 Defendants Lehman Brothers, Inc., Goldman Sachs & Co., and Morgan Stanley & Co., Inc. are international financial services firms and investment banks. Lehman, Goldman, and Morgan Stanley are all broker-dealers registered with the United States Securities and Exchange Commission, and are members of all major securities and commodities exchanges, including the New York Stock Exchange and National Association of Securities Dealers.*fn3

  B. The Interplay Between Investment Banking and Research Divisions at the Banks

  Each of the Banks provide both investment banking and financial advising services to clients. As investment banks, the Banks engaged in securities offerings — including initial public offerings (IPOs), secondary offerings and debt financing — and provided merger and acquisition services.*fn4 The Banks actively competed for investment banking business, and in particular for positions as lead manager, underwriter, or placement agent for securities offerings.*fn5 In 2001, for example, Lehman earned approximately $1.3 billion from such underwriting services.*fn6 Investment banking business was lucrative not only in its own right, but also because it provided the basis for a working relationship that often brought the Banks additional transactional and advisory work.*fn7

  In addition to investment banking, the Banks provided market research and analysis for their clients. Analysts collect information about a particular industry and the companies that comprise it, and develop recommendations to investors based on that information.*fn8

  Analysts' reports compile a variety of predictions about a particular company, including anticipated earnings, revenue and cash flow, and dividend potential. They also assess a company's operating and financial strengths and weaknesses, and predict its long-term profitability.*fn9 All of the information in a research report is distilled into a single recommendation, or "rank." For example, Lehman's analyst reports ranked companies from one through five: 1-Buy (meaning that the company was expected to outperform the market by more than 15 percent); 2-Outperform (expected to outperform the market by 5-15 percent); 3-Neutral (expected to perform within five percent of the market, either way); 4-Underperform (expected to underperform the market by 15 or more percent); 5-Sell.*fn10 Plaintiffs allege, however, that the Banks had a secret policy to never (or very rarely) use the lowest ratings, turning a five-point scale into a de facto four_point scale.*fn11 Research reports also carried another critical value: a stock price target, designed to reflect the anticipated market price of the company's stock at some time in the future.*fn12

  Lehman, for instance, provided analyst coverage for approximately 80 different "sectors" for a total of approximately 900 individual companies.*fn13 These reports were widely distributed, both directly to the Banks' clients and to large institutional investors, as well as indirectly to the public, through the media and various public services.*fn14 Critical to the value of these reports was that the Banks held them out to be based on accurate information and to contain independent and unbiased recommendations on which the investing public could rely.*fn15

  According to plaintiffs, however, the Banks' analysts were tainted by conflicts of interest that caused them to make fraudulent recommendations in their reports, suggesting that the securities of investment banking clients were more valuable than they actually were. Those conflicts of interest arose for a number of reasons.

  First, analysts were called on to help win important investment banking business.*fn16 This required an extraordinary level of coordination between investment bankers and research analysts.*fn17 Indeed, a 1999 memorandum from Lehman's Managing Director of Global Equity Research circulated to key personnel in the research department underscored the importance of research analysts to the acquisition of investment banking business. Towards that end, the memorandum explained that "to ensure we have a proper recognition of analysts' impact on banking, we have to closely track every dollar of IBD [Investment Banking Department] revenue (equity, M& A, debt) by analyst."*fn18

  Second, the Banks instituted "360 degree" review policies for analysts, whereby analysts' job performances were reviewed not only by their superiors within the research department, but also by investment bankers who dealt with the clients that the analysts' research covered.*fn19 Among the explicit criteria for reviewing analysts were to what extent they were prioritizing the acquisition of banking business and their effectiveness in recruiting banking clients.*fn20 Indeed, analysts at Goldman were required to fill out "business plan" forms that included details about how the analyst intended to help win investment banking business.*fn21 To underscore the importance of banking fees, one analyst responded to the question, "what are the three most important goals for you in 2000?" with the answer, "1. Get more investment banking revenue. 2. Get more investment banking revenue. 3. Get more investment banking revenue."*fn22 Third, analyst compensation was directly tied to investment banking.

  At Lehman, for instance, investment bankers were explicitly consulted about analyst compensation.*fn23 This was particularly important given analysts' salary structure. Analysts typically received small base salaries accompanied by much larger bonuses; the bonuses, in turn, were computed based on the analysts' ability to bring in banking business.*fn24 One analyst at Lehman, for example, received a base salary of $200,000 per year and a bonus that could range from $4.8 to $8.8 million, depending entirely (and explicitly) on the aggregate investment banking fees that he generated.*fn25 Even analysts whose bonuses were not explicitly tied to banking business never doubted that their bonuses depended on banking fees.*fn26 Analysts often cited the investment banking fees that they generated as evidence that they deserved certain compensation or promotions.*fn27 Not surprisingly, the close relationship between investment banks and analysts created pressure on analysts to refer business to banking (e.g., by identifying sectors of the economy that bankers should target), and to tailor research reports to the needs of bankers. Investment bankers understood that if their analysts covered a particular company, it would help the bankers get business from that company.*fn28 And if the analysts issued positive recommendations regarding the company — regardless of the company's actual market outlook — this would be good for the investment bankers.*fn29 Towards that end, bankers routinely reviewed analyst reports before the reports were released.*fn30 And analysts consulted bankers — and sometimes even the companies themselves — before changing recommendations or altering their research coverage.*fn31

  Bankers thus used analysts and research reports to recruit new business. Analysts would accompany bankers to "pitch meetings" for the purpose of guaranteeing analyst coverage to the company; the company was also shown the effect of positive analyst reports on the price of its stock.*fn32 In some cases, explicit promises were allegedly made: one Lehman pitch promised that the analyst "will lead a powerful marketing campaign" for the company, presumably through positive reports.*fn33 The inevitable result of the close relationship between banking and research, coupled with the tremendous pressure on analysts to help investment bankers acquire business, was the issuance of research reports that were exaggerated or outright fabricated.*fn34

  C. The Banks' Business With RSL

  It was in this market environment that the Banks formed a working relationship — both investment banking and research — with RSL. Lehman generated over $64 million in investment banking fees as lead or co-lead underwriter for: (a) the RSL IPO in 1997; (b) a high yield note placement in December 1998; (c) RSL's spin-off IPO of deltathree.com on September 3, 1999; (d) RSL's Consent Solicitation Statement, on September 13, 1999; (e) the issuance of $200 million in 12 7/8 percent Senior Notes in February 2000; and (f) the issuance of $114 million aggregate liquidation preference of 7 1/2 percent Series A preferred shares in February 2000.*fn35 With respect to its placement of Series A preferred shares, Lehman exercised its own over-allotment option to acquire an additional $15 million in preferred stock, which it then sold as part of the placement.*fn36

  Goldman also generated over $64 million in investment banking fees as lead or co-lead underwriter for: (a) the RSLIPO in 1997; (b) the offering of 9 7/8 percent Senior notes in May 1999; (c) RSL's spin-off IPO of deltathree.com on September 3, 1999; (d) the issuance of $200 million in 12 7/8 percent Senior Notes in February 2000; and (e) the issuance of $114 million aggregate liquidation preference of 7 1/2 percent Series A preferred shares in February 2000.*fn37 With respect to its placement of Series A preferred shares, Goldman exercised its own over-allotment option to acquire an additional $15 million in preferred stock, which it then sold as part of the placement.*fn38

  Finally, Morgan Stanley also generated over $64 million in investment banking fees as lead or co-lead underwriter for: (a) the RSL IPO in 1997; (b) the issuance of $200 million in 12 7/8 percent Senior Notes in February 2000; and (c) the issuance of $114 million aggregate liquidation preference of 7 1/2 percent Series A preferred shares in February 2000.*fn39 With respect to its placement of Series A preferred shares, Morgan Stanley exercised its own over-allotment option to acquire an additional $15 million in preferred stock, which it then sold as part of the placement.*fn40

  D. The Banks' False and Misleading Research Coverage of RSL

  During the period of time that the Banks were doing investment banking work for RSL, they were also providing analyst coverage of RSL's common stock.

  1. Lehman's Research Coverage

  Between April 30, 1999, and July 9, 1999, Lehman issued three reports characterizing RSL's stock as "real cheap," touting the importance of the deltathree.com IPO, and giving RSL its highest buy recommendation.*fn41 In response to these reports, the price of RSL's common stock rose by approximately $1, $3, and $2 per share, respectively. Lehman was subsequently appointed lead underwriter of the deltathree.com spin-off, for which it received approximately $5 million in fees.*fn42 On September 7, 1999, shortly after the deltathree.com IPO, Lehman resumed its "1-Buy" recommendation, although in fact Lehman's analysts "thought little about Delta 3's long-term prospects after the IPO had been successfully sold to its investors."*fn43 On November 1, 1999, Lehman again rated RSL "1-Buy" with a price target of $40 per share (it was then trading at $20 3/16 per share); as a result, RSL common stock rose by approximately $3 per share.*fn44

  By February 2000, RSL was trading at $17 per share and some analysts at Lehman wanted to downgrade the stock. One analyst even prepared a draft report that, while lowering the price target for RSL, maintained a "bullish" price target of $35 per share.*fn45 The draft report began, "We are revising our Revenue and EBITDA estimates for RSL to reflect declining revenue from U.S. prepaid and wholesale and more moderate ramp in European retail revenue."*fn46

  The investment banker handling the RSL account, however, prevailed on the analyst to maintain the $40 per share price target; the actual report that was issued on March 2, 2000, began: "RSL's European unit posted strong sequential revenue growth in Q4 . . .,"*fn47 And on March 9 and 10, Lehman issued additional reports that raised the RSL price target to $50 per share.*fn48 By then, RSL was trading at $32.

  Lehman maintained the $50 price target and "1-Buy" rating in a report issued May 5, 2000, notwithstanding that RSL had by then dropped to $15.50 per share.*fn49 By August 14, 2000, RSL's stock had declined to $4 per share and the Lehman analyst covering RSL was fed up. In an e-mail to his supervisor, he wrote:
Enough is enough. It's hard enough to be right about stocks, it's even harder to build customer relationships when all your companies blow up, you knew they were going to, and you couldn't say anything.
[F]or the record, I have attempted to downgrade RSLC THREE times over the last year, but have been held off for ...

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