Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 86 C 778 -- Susan Getzendanner, Judge.
Cummings, Easterbrook, and Manion, Circuit Judges.
EASTERBROOK, Circuit Judge.
For many years Henry C. Lytton & Co., which operated a number of department stores, was a subsidiary of Cluett, Peabody & Co. In 1983 Cluett sold its stock in Lytton for $14.5 million to LHLC Corp., a closely-held firm that financed the acquisition almost entirely by debt, which it hoped to repay out of income from Lytton's future operations. Almost $8 million of the purchase price represented the estimated value of Lytton's inventory. Less than a year after acquiring Lytton's, LHLC Corp. filed for bankruptcy. Among its creditors, to the tune of about $180,000, was Cluett, which sold goods to LHLC on open account.
LHLC believes that Cluett misrepresented the value of Lytton's inventory, inducing LHLC to pay a price higher than the facts warranted. It filed this suit under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and the SEC's Rule 10b-5, 17 C.F.R. § 240. 10b-5, with pendent claims under state law. The suit may proceed even though Cluett sold LHLC the entire business. Landreth Timber Co. v. Landreth, 471 U.S. 681, 85 L. Ed. 2d 692, 105 S. Ct. 2297 (1985). According to the complaint, after Cluett had failed to sell goods on which markdowns had been taken, it placed the merchandise back in inventory and told LHLC that it was salable at retail price. Cluett did not allow LHLC to inspect the inventory before the sale (for fear that this would disrupt operations and impair the morale of the staff); the contract of sale contains not only Cluett's warranty of the value of the inventory but also a statement that LHLC "strictly relied" on Cluett's representations.
LHLC named Deloitte, Haskins & Sells, Cluett's accountant, as a second defendant. The contract between Cluett and LHLC required Cluett to furnish LHLC with a report of the value of the inventory. The report, which Deloitte approved, showed that the inventory was properly valued at some $7.9 million in accordance with generally accepted accounting principles. LHLC believes that this, too, was false and fraudulent; it characterizes Deloitte as Cluett's aider and abetter.
The district court granted summary judgment to Cluett on the ground that LHLC is estopped to pursue any remedy against it, dismissed the securities claim against Deloitte for failure to state a claim on which relief may be granted, 665 F. Supp. 637 (N.D.Ill. 1987), and dismissed the pendent state claims against Deloitte for lack of subject-matter jurisdiction. We start with the claim against Deloitte.
A deal of this kind depends on an accurate valuation of the assets of the firm being sold. That value changes from day to day. The parties recognized this and assessed the worth of the assets on at least three occasions. One was at the end of December 1982, when Cluett furnished LHLC a tentative valuation of the inventory, cash, receivables, and other fluctuating items. The second was on February 4, 1983, the date of closing, when Cluett informed LHLC of its estimate of the value of the inventory (and the other fluctuating items) as of January 31, 1983, the date the parties had chosen for fixing the price. LHLC paid the price implied by Cluett's estimates. The third was in March 1983, when Cluett drew up a final statement of the actual January 31 values that had been estimated on February 4. The contract required the parties to make adjustments in the price for any differences between the preliminary estimate of February 4 and the final estimate of March.
The value of the inventory was estimated on each occasion; unlike cash on hand, it could not be measured with precision. On February 4 Cluett furnished LHLC with an "inducement letter" stating that it would provide a final valuation of the inventory in accordance with generally accepted accounting principles, and that its accountant would so certify. Cluett drew up a balance sheet, assessing the worth of the inventory at $7.9 million as of January 31, 1983. Deloitte sent Cluett a letter, dated March 7, 1983, stating that this balance sheet fairly represented the value of the inventory in accordance with generally accepted accounting principles. Cluett relayed this letter to LHLC. This is the only writing signed by Deloitte that reached LHLC. LHLC says that Cluett's estimate is $2.7 million high, and that Deloitte's letter, like Cluett's balance sheet, is fraudulent.
LHLC's difficulty is that the communication from Deloitte arrived after the closing. It was too late for LHLC to back out of the sale. LHLC made its investment on February 4, 1983. Only the potential for litigation remained. The most it could have done -- if, say, Deloitte's letter had said that Cluett's figure was too high and that the proper figure was $5.2 million -- would have been to make a claim against Cluett under the warranty.
The district judge concluded that any misstatements in Deloitte's letter were not "material" because they did not affect LHLC's decision to close the transaction on February 4. 665 F. Supp. at 639-41. One could say equivalently, and perhaps more accurately, that nothing Deloitte did or could have done caused LHLC to make an investment decision. Materiality has an element of causation built in, because a statement is material only if it so alters the "total mix" of information available to the investor that it has the potential to affect the decision. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449, 48 L. Ed. 2d 757, 96 S. Ct. 2126 (1976). But materiality usually refers to the importance of the information; a datum that would have only a small effect on the price is not material, while a datum with the potential for a larger effect is. The valuation of the inventory ($7.9 million versus $5.2 million) would be material in this usual sense, except for the fact that Deloitte did not communicate with LHLC until after the closing. By then it was too late. The information, even if conventionally "material", did not affect the investment decision.
Ever since Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380-81 (2d Cir. 1974), courts have been distinguishing between "transaction causation" and "loss causation". See Thomas Lee Hazen, The Law of Securities Regulation § 11.5 (1985) (collecting cases). Currie v. Cayman Resources Corp., 835 F.2d 780, 785-86 (11th Cir. 1988), is a recent example. The plaintiff must show both. "Loss causation" means that the investor would not have suffered a loss if the facts were what he believed them to be; "transaction causation" means that the investor would not have engaged in the transaction had the other party made truthful statements at the time required. These terms, ungainly to start with because they conscript nouns for service as adjectives, have been confusing in practice because they do not link the definition of "causation" to any theory about why people might be liable under the securities laws. The "transaction" in question is undefined. It is almost always possible to show that a given disclosure or nondisclosure could have affected some transaction, at some level of probability. Used without care, these terms hinder rather than facilitate understanding. See Hazen at 321; Richard Jennings & Harold Marsh, Securities Regulation: Cases and Materials 1047 (5th ed. 1982). What should happen when the missing information affected a decision not to file a lawsuit about the securities, as in Goldberg v. Meridor, 567 F.2d 209 (2d Cir. 1977)?
We have suggested in recent years that the appropriate inquiry is whether the information disclosed or withheld affected an investment decision. E.g., Harris Trust & Savings Bank v. Ellis, 810 F.2d 700, 704 (7th Cir. 1987) (collecting cases). See also, e.g., Rand v. Anaconda-Ericsson, Inc., 794 F.2d 843, 847-48 (2d Cir. 1986). The securities laws single out investment decisions concerning financial instruments from among the many decisions people must make. Whether to buy a house or go to school or take a job or file a suit may be important, but the securities laws do not apply to these decisions. The securities laws deal with instruments that have at least the potential to be traded in liquid markets, see Marine Bank v. Weaver, 455 U.S. 551 560, 71 L. Ed. 2d 409, 102 S. Ct. 1220 (1982). Information about these instruments should be compiled and released by a single source, usually the issuer, to facilitate both trading among passive investors and the ability to compare the prospects of one firm against the prospects of others -- a comparison essential if capital is to flow to its most valuable uses. If a person is locked into possession of a security, however, disclosure serves neither of these functions. Capital has ...