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DALTON v. ALSTON & BIRD

June 12, 1990

WILLIAM F. DALTON, individually and as a representative of a Bondholder Class, Plaintiffs,
v.
ALSTON & BIRD et al., Defendants



The opinion of the court was delivered by: FOREMAN

 This case arises from the default of First Mortgage Medical Facility Revenue Bonds ("bonds" or "bond issue") issued by the Jefferson County Health Facilities Authority, Inc. ("the Authority"). As this action is ready to proceed to trial, the defendants, in various combinations, have filed twenty-nine motions for summary judgment or dismissal. The motions raise some issues raised earlier in the litigation, which the Court addressed in Goldwater v. Alston & Bird (Goldwater I), 664 F. Supp. 403 (S.D. Ill. 1986) and Goldwater v. Alston & Bird (Goldwater II), 116 F.R.D. 342 (S.D. Ill. 1987). *fn1" The Court now has the opportunity to address some questions left open in both Goldwater decisions, as well as other issues raised for the first time.

 I.

 This case begins with the financial difficulties of a 50-bed hospital known as the Jefferson Memorial Hospital Association ("Jefferson Hospital") in Mount Vernon, Illinois. The operation of the hospital in the early 1970's had been a financial disaster. By 1975, the occupancy rate had declined to 50 per cent, and by 1978 the occupancy rate had fallen to 34 per cent. The Hospital was in a state of disrepair and could not purchase modern equipment. Jefferson Hospital could not compete with neighboring hospitals, and filed for bankruptcy. Its certification was revoked by the Illinois Department of Health and as of November, 1979, the hospital was closed.

 Prior to filing for bankruptcy, Jefferson Hospital had obtained a permit from the Illinois Department of Health to relocate to two nearby nursing homes, Hickory Grove Manor and View Manor. Jefferson Hospital had planned to convert these facilities into a combined acute care hospital and nursing home. In 1977, Jefferson Hospital contracted with UDE Corporation to secure financing to convert the Hickory Grove facility and with UDE, Inc., a wholly owned subsidiary of UDE Corporation, *fn2" to be general contractor for the project. UDE Corporation is controlled by Art Lewis and Glen Lewis (the Lewises).

 UDE Corporation could not obtain sufficient financing for the conversion. It could only obtain short term bank loans at a high interest rate. That caused the conversion of the hospital portion of the facility to halt while the nursing care section was unable to meet state standards for acute care patients. As a result, the hospital lost its licensing as a skilled nursing facility and lost its Medicare certification by the Department of Health, Education and Welfare.

 On November 2, 1979, the Lewises, through an entity called the Grove Partnership, purchased the Hickory Grove facility. Another partnership controlled by the Lewises, the View partnership, acquired an adjacent property known as the Hickory View Manor Nursing Home. The complaint alleges that in order to salvage the financing and construction deal entered into by the UDE companies, the Lewises, with the aid of their attorneys Gallop, Johnson, Crebs & Neuman (Gallop, Johnson), *fn3" formed the Jefferson County Health Facilities Authority, Inc., to issue bonds to finance the purchase of the Hickory Grove and Hickory View Manor nursing homes. The underwriter for this bond issue was Hereth, Orr and Jones (HOJ). At the same time, the Lewises also formed Mt. Vernon Hospital, Inc. (Mt. Vernon Hospital), as a not-for-profit corporation to lease and operate the facilities. Mt. Vernon Hospital subsequently retained Hospital Management Associates (HMA) *fn4" to act as management consultants for the new hospital.

 St. Louis Union Trust Co. *fn5" (Boatmen's Trust) acted as the indenture trustee for this bond issue. According to the terms of the indenture, Boatmen's was to make payments to UDE, Inc., upon the receipt of certain documentation from the Mt. Vernon Hospital. At the time of the indenture, Boatmen's Trust's sister bank, Boatmen's Bank, had made loans to UDE Corporation.

 Price Waterhouse & Co. (Price Waterhouse) prepared the financial statements used in the offering statements. The financial statements assumed a patient occupancy rate of 80%. The financial forecast also included a projection of revenues for the hospital. The projection was based on a rate of $ 123.00 per inpatient day. The projection also assumed that the new facility would receive prompt Medicare certification. Peter Wright (Wright) of the law firm of Jones, Bird & Howell (Jones, Bird), *fn6" acted as counsel for the bond issue. Among the expert statements made by Jones, Bird was the representation that the bonds were tax-exempt under Internal Revenue Code Section 103, 26 U.S.C. § 103. The bonds were eventually granted tax-exempt status under Internal Revenue Code Section 501(c)(3), 26 U.S.C. § 501(c)(3).

 After the bonds were issued and sold in 1980, the venture ran into difficulties. Despite representations in the offering statement that the new hospital would receive timely Medicare certification, certification was denied. *fn7" Furthermore, there were delays in completing the construction of the hospital. Because of these and other difficulties, the hospital could not operate at the predicted occupancy rate. Consequently, the bond issue went into default in February, 1982.

 This complaint is brought on behalf of the purchasers of the bond issue. *fn8" The complaint states six causes of action: 1) a claim predicated on Rule 10b-5 and the Illinois Securities Act; 2) a claim under the RICO statute; 3) negligence against Alston & Bird and Jones, Bird, and against Price Waterhouse; 4) breach of contract against Alston & Bird and Jones, Bird; 5) breach of fiduciary duty against Boatmen's Trust; 6) a claim under Section 12(2) of the 1933 Securities Act.

 II.

 A Court may grant summary judgment only if the party seeking summary judgment demonstrates that no genuine issue of fact exists for trial and that the movant is entitled to judgment as a matter of law. Fed. R. Civ. P. 56(e); Wilson v. Chicago, Milwaukee, St. Paul & Pacific R.R. Co., 841 F.2d 1347, 1354 (7th Cir. 1988), petition for cert. dismissed in 487 U.S. 1244, 109 S. Ct. 1, 101 L. Ed. 2d 953 (1989). If that showing is made and the motion's opponent would bear the burden at trial on the matter that forms the basis of the motion, the opponent must come forth with evidence to show what facts are in actual dispute. Celotex Corp. v. Catrett, 477 U.S. 317, 324, 106 S. Ct. 2548, 91 L. Ed. 2d 265 (1986); Donald v. Polk County, 836 F.2d 376, 379 (7th Cir. 1988). Where the moving party fails to meet its strict burden of proof, summary judgment cannot be entered even if the opposing party fails to respond to the motion. Yorger v. Pittsburgh Corning Corp., 733 F.2d 1215, 1222 (7th Cir. 1984).

 When the parties do not dispute the factual basis of a motion for summary judgment, the court's only inquiry is whether judgment should issue as a matter of law. The burden of proof on this matter rests with the moving party. Summary judgment is inappropriate, however, if the parties disagree about inferences reasonably to be drawn from undisputed facts. Bowyer v. United States Dept. of Air Force, 804 F.2d 428, 430 (7th Cir. 1986), cert. denied 493 U.S. 1046, 110 S. Ct. 846, 107 L. Ed. 2d 840 (1990).

 When the parties dispute the facts, the parties must produce proper documentary evidence to support their contentions. The parties cannot rest on mere allegations in the pleadings, Boruski v. United States, 803 F.2d 1421, 1428 (7th Cir. 1986), or upon conclusory allegations in affidavits. First Commodity Traders v. Heinold Commodities, 766 F.2d 1007, 1011 (7th Cir. 1985). The Court must view the evidence and any permissible inferences from the materials before it in favor of the non-moving party, Matsushita Elecs. Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 588-89, 106 S. Ct. 1348, 89 L. Ed. 2d 538 (1986), as long as the inferences are reasonable. Davis v. City of Chicago, 841 F.2d 186, 189 (7th Cir. 1988). The non-moving party must show that the disputed fact is material; that is, it must be outcome-determinative under the applicable law. Wainwright Bank & Trust Co. v. Railroadmens Fed. Sav. & Loan Ass'n, 806 F.2d 146, 149 (7th Cir. 1986).

 III.

 In order to prevail in a private cause of action under Section 10 of the 1934 Securities Exchange Act, 15 U.S.C. § 78j, and Rule 10b-5, 17 C.F.R. § 240.10b-5, a plaintiff must show that the defendant used a facility of interstate commerce to do any of the following in connection with the purchase or sale of a security: 1) employ any device, scheme, or artifice to defraud; 2) make any untrue statement or material omission; or 3) engage in any act which would operate as a fraud. Id. In implying a private right of action under this rule, courts have imposed the additional requirements of scienter, reliance, causation and materiality. See Loss, Fundamentals of Securities Regulation 1125 (1983).

 The element of reliance has been expanded by courts in recent times. In Basic, Inc. v. Levinson, 485 U.S. 224, 108 S. Ct. 978, 99 L. Ed. 2d 194 (1988) (Rehnquist, C.J., and Scalia and Kennedy, JJ., not participating), the Supreme Court allowed a plaintiff to draw a presumption of reliance based on the integrity of the market. The Court reasoned that, in an effective market in actively traded securities, the market price reflects all relevant information. Therefore, even a plaintiff who did not rely on the specific acts or omissions of the defendant could rely on the market price of the security purchased to reflect those acts or omissions since they operate as a fraud on the market.

 Although fraud on the market has its Basic application in a developed and active market, the Fifth Circuit in Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981) (en banc), cert. denied, 459 U.S. 1102, 103 S. Ct. 722, 74 L. Ed. 2d 949 (1983), extended the rationale to an undeveloped (new issues) market. Shores stated that an investor in a new issue obviously cannot rely on the integrity of the market to determine a price for issue; therefore, in a new issue case, to show reliance the purchaser must show that the bonds were not entitled to be marketed at any price. Id. at 470.

 In an earlier opinion, this Court adopted the Shores rationale. Goldwater I, 664 F. Supp. at 409-411. The Court cautioned, however, that it remained to be seen whether the plaintiff could show that the bond issue could not have been marketed at any price. Id. at 411. The defendants have now challenged the ability of the plaintiffs to show the unmarketability of the bond issue. This requires the Court to first determine as a matter of law what is meant by the standard "not entitled to be marketed"; *fn9" next, the Court must determine whether there is a material issue of fact as to whether the bond issue was unmarketable measured against this standard.

 The standard for determining whether a security is not entitled to be marketed at any price must be defined in terms of the Shores rationale. In Shores, the court held that, although an investor in a new issue cannot rely on the integrity of the market to determine the price of a security, an investor may rely on the market for protection from certain other risks. Shores, 647 F.2d at 470-471.

 An example of such a risk is found in T.J. Raney & Sons, Inc. v. Fort Cobb, Oklahoma Irrigation Fuel Authority, 717 F.2d 1330 (10th Cir. 1983), cert. denied 465 U.S. 1026, 104 S. Ct. 1285, 79 L. Ed. 2d 687. The court there held that the bonds were not entitled to be marketed because they were not validly issued under substantive state law. Id. at 1333. In other words, if the bonds were not authorized to be issued under substantive state law, they would clearly be unmarketable. This Court has previously rejected the contention that the T.J. Raney test was the exclusive test for determining whether a bond issue was unmarketable at any price. Goldwater I, 664 F. Supp. at 411. However, T.J. Raney shows one example of a fraud which would make securities not entitled to be marketed at any price.

 An investor in a new issue may also rely on the integrity of the market as to the terms of the security. If a bond is offered as a thirty year bond bearing an interest rate of 12.25%, an investor can rely on the bond being a 12.25% thirty year bond. This, of course, does not mean that an investor can rely on receiving 12.25% over the course of thirty years, or that an investor can rely on receiving a full return on the principal. Those items relate to the risk inherent in the bond issue. It merely means that a purchaser of a new issue may rely on the face terms of the bond to be the same as the terms at which the bond is marketed.

 This Court has also previously recognized that the question of the tax exemption of the bonds is relevant in determining whether a fraud on the market existed in this case. Goldwater II, 116 F.R.D. at 350. The tax status of these bonds is the subject of a different motion discussed below. For purposes of the fraud on the market theory, it suffices to say that the bonds were eventually ruled tax-exempt under Internal Revenue Code § 501(c)(3), 26 U.S.C. § 501(c)(3). An investor in the tax-free bond market can rely on the tax-exempt status of the bonds, but cannot rely on the specific Internal Revenue Code section under which the bonds became tax-exempt. *fn10"

 Last, investors may rely on the intent of the promoters to carry out the project for which the issue is sold. Abell v. Potomac Insurance Co., 858 F.2d 1104, 1122 (5th Cir. 1988), cert. denied, 492 U.S. 918, 109 S. Ct. 3242, 106 L. Ed. 2d 589. An investor who purchases the bond need not make independent investigation that a project actually exists or into the intent of the promoters to invest in a project.

 All courts which have addressed this issue have also added an element of scienter to this analysis. Abell, 858 F.2d 1104, 1122; Ross v. Bank South, N.A., 885 F.2d 723, 729 (11th Cir. 1989) (en banc); Stinson v. Van Valley Development Corp., 719 F. Supp. 362, 366 (E.D.Pa. 1989), aff'd. 897 F.2d 524 (3d Cir. 1990) (adopting the rule in Abell). This Court agrees that the investor in a new issue can only rely on the integrity of the market to protect him or her from frauds which the promoter intends or dangers which the promoter recklessly disregards. The new issues market does not protect the investor from the incompetence or negligence of the promoter.

 The Court rejects the "no chance of success" test urged by the plaintiffs in this litigation. An investor who has not read the offering statements cannot rely on the integrity of the market to weed out the high risk ventures. Indeed, new issues are inherently risky and any investor who enters the market without obtaining adequate information about the risks involved in the venture cannot rely on the integrity of the market for protection.

 Moreover, the "no chance of success" test is unworkable in practice. Arguably, every venture has some chance of success under the most improbable set of circumstances, and thus has some value. Cf. Ross, 885 F.2d at 736 (Tjoflat, J., concurring) ("no matter how great the risk of nonpayment, a bond can virtually always be sold at some combination of price and interest rate"). By adopting the "no chance of success" formulation, the courts would then, necessarily, draw an even finer line of determining what the appropriate chance of success is. *fn11"

 In short, a new issue is marketable at some price if it is what it claims to be: a validly issued security, the terms of which are the same as the terms at which it is offered, the proceeds of which are intended to be used to finance some project. To successfully allege and prove a claim for relief under this theory, the purchaser of a security must show that the promoter of the venture was aware of or recklessly disregarded the infirmity in the security. Beyond ...


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