The opinion of the court was delivered by: REBECCA R. PALLMEYER
The Honorable George W. Lindberg
Magistrate Judge Rebecca R. Pallmeyer
REPORT AND RECOMMENDATION
In November 1988, Defendant Specialty Equipment Companies, Inc. ("Specialty"), the sole subsidiary of Defendant SPE Acquisition, Inc. ("SPE Acquisition"), issued and offered for sale to the public "Senior Subordinated Debentures" ("Debentures") valued at $ 150,000,000 in an attempt to raise revenue to repay part of the financing debt incurred when SPE Acquisition purchased Specialty. Plaintiffs Melvin C. Nielsen ("Nielsen") and Peter C. Kostantacos ("Kostantacos"), who purchased Debentures worth $ 100,000 and $ 50,000 respectively, brought this class action against SPE Acquisition; Specialty; Specialty's directors and officers; the co-underwriters of the November public offering; and General Electric Capital Corporation ("GECC"), which helped finance SPE Acquisition's purchase of Specialty. The action is brought on behalf of a proposed class of all persons who purchased the Debentures between November 15, 1988 and March 16, 1991.
Defendant Specialty, a Delaware corporation with executive offices in Illinois, manufactures and markets institutional food service equipment. Defendant SPE Acquisition is a Delaware corporation owned by certain members of Specialty's management and formed for the purpose of acquiring Specialty. Defendants Daniel B. Greenwood, James B. Knoll, Carl Gorychka, Carl F. Wangaard, William E. Dotterweich, Donald K. McKay, William W. Robertson, and Gregory J. Ziols are the officers and directors of Specialty. Defendant GECC, the senior lender, is a New York corporation maintaining an office in Chicago, Illinois. GECC is owned by General Electric Financial Services, Inc. Defendant Kidder, Peabody & Co. ("Kidder"), one of the underwriters for the Debenture offering, is an investment banking firm engaged in the underwriting of securities and maintains its principal offices in New York, New York. Kidder is also owned by General Electric Financial Services. Defendant Piper, Jaffray & Hopwood ("PJH"), the other underwriter, is an investment banking firm engaged in the business of underwriting securities and maintains its principal executive offices in Minneapolis, Minnesota.
Plaintiffs filed a five-count Amended Complaint on October 17, 1991. The Amended Complaint charges Defendants with violations of § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 (Count I), §§ 11 and 12 of the Securities Act of 1933 (Counts II and III), common law fraud (Count IV), and negligence (Count V).
In December 1991, Defendants Specialty Equipment Companies, Inc. and SPE Acquisition, Inc. filed a motion to dismiss pursuant to FED. R. CIV. P. 12(b)(6) for failure to state a claim upon which relief can be granted. On December 18, 1991 Judge Lindberg denied that motion on the basis that it improperly relied on matters outside of Plaintiffs' complaint. Defendants Specialty and SPE Acquisition moved for reconsideration; prior to a ruling, however, Specialty and SPE Acquisition filed for protection in bankruptcy court. All proceedings concerning them have been stayed by this court pursuant to an order dated January 8, 1992. The officers and directors of Specialty have adopted Specialty's motion to dismiss and for reconsideration, however. In addition, in January 1992, Defendant GECC moved to dismiss the § 10(b) claim and common law fraud claims. FED. R. CIV. P. 12(b)(6); 9(b). In January 1992, Defendant Kidder also moved to dismiss all counts against it for failure to state a claim.
On January 6, 1992, Defendant PJH moved to stay the proceedings and to compel arbitration of all Plaintiffs' claims against PJH. Plaintiffs moved to certify the class action on January 8, 1992; Judge Lindberg deferred ruling on the certification motion pending rulings on the motions to dismiss.
On January 22, 1992, Defendant PJH reasserted its motion to stay the proceedings and compel arbitration. The following month, the case was referred to these chambers pursuant to Local General Rule 2.41(b). Defendant PJH's motion to stay proceedings and compel arbitration and Defendants' three motions to dismiss are now before this court. Also pending are Defendants' motions for stay of discovery pending the court's ruling on the motions to dismiss. PJH's motion to compel is addressed in a separate Report and Recommendation issued simultaneously with this one. This Report addresses the three motions to dismiss and recommends that they be granted in part and denied in part for the reasons discussed below.
For purposes of the motions before the court, the facts alleged in the Amended Complaint, summarized below, are presumed true.
Defendant Specialty designs, manufactures, and markets a "broad line of commercial and institutional food service equipment." (Amended Complaint, P 7(b).) In 1988, "certain members of the management of Specialty" (the Amended Complaint does not identify them by name) decided to buy Specialty from its original owners. (Id. PP (a), 22, 23.) As part of this effort, these individuals formed SPE Acquisition. (Id. P 8.) Through a subsidiary, SPE Acquisition Sub, SPE Acquisition "made an all cash tender offer for the common and preferred stock of [Specialty]." (Id. P 23(a)(i).) Pursuant to this offer, on September 9, 1988, SPE Acquisition Sub purchased 6,132,527 shares of Specialty's common stock and all 3,680 shares of Specialty's preferred stock for approximately $ 300 million. (Id. P 23(a)(ii).) SPE Acquisition then merged SPE Acquisition Sub into Specialty, thus rendering Specialty the sole subsidiary of SPE Acquisition. (Id. P 23(a)(iii).)
SPE Acquisition financed this purchase with a $ 283 million interim loan from Defendant GECC. (Id. P 23(b).) The total amount required to complete the transaction, however, ultimately reached $ 500.3 million. (Id. P 24.) In order to cover the difference, SPE Acquisition converted its loan from GECC into "permanent financing" which consisted of several loans under a "Senior Loan Agreement," with GECC as both an agent and a member of the senior lender group. SPE Acquisition also took on additional independent debt. (Id. P 24.) The Senior Loan Agreement included (1) a "12-year, $ 225 million senior term loan . . . entered into between [Specialty] and [the senior] lender group," and (2) a "10-year $ 70 million revolving line of credit." (Id. P 24(i)(ii).) In addition to the financing under the Senior Loan Agreement, SPE Acquisition received financing consisting of (1) a "$ 150 million bridge loan" from Kidder Peabody Group, Inc., a subsidiary of Defendant Kidder; (2) "investment by management of $ 8.3 million (consisting of $ 400,000 in cash and $ 7.9 million in options, rights and warrants) in return for common stock of SPE Acquisition"; and, (3) a "purchase of $ 47 million in 9.5% cumulative preferred stock and warrants for up to 70% of the common stock of SPE Acquisition" by members of the senior lender group. (Id. P 24(iii)(iv)(v).)
Pursuant to Specialty's public offering, Plaintiff Peter Kostantacos and Plaintiff Melvin Nielsen, both of Rockford, Illinois, purchased Debentures worth $ 50,000 and $ 100,000, respectively in November 1988 and February 1990. (Id. P 6.)
In conjunction with this sale, Specialty and certain of its officers and directors prepared and filed with the Securities & Exchange Commission a Registration Statement, including a Prospectus, which purported to describe the risks associated with the Debentures in light of Specialty's debt load (i.e. the "permanent financing"), the subordinate position of the Debentures to the rights of the senior lender group as provided in the Senior Loan Agreement, and the remedies available to the senior lender group under the Senior Loan Agreement in the event of any default by Specialty. As more fully described below, Plaintiffs allege that the Prospectus contains material misrepresentations and omissions. (Id. P 2.)
Before considering Plaintiffs' specific challenges, a brief overall review of the Prospectus is appropriate. The Prospectus is a 53-page document, exclusive of financial statements attached as exhibits. In spite of its length and detail, the Prospectus states at its outset that it does not contain all of the information in the Registration Statement and that statements appearing in the Prospectus are qualified in all respects by the Registration Statement. (Prospectus, at 2.)
A. Description of Risk Factors
A lengthy description entitled "RISK FACTORS" begins at page 7 of the Prospectus. That description points out that Specialty (referred to in the Prospectus as "the Company") is highly leveraged and has long-term debt of approximately 92.5% of its total capitalization. (Id. at 7.) It states, further, that although the Company "believes that its cash flow from operations" will meet debt service obligations, "there can be no assurance that it will be able to do so." Potential investors are reminded that Debentures will be subordinated "to all Senior Debt (as defined in the Indenture), including the Senior Term Loan and borrowings under the Revolving Credit Facility." (Id.) Accordingly, in the event of a default resulting in acceleration of the Senior Debt, including a default in payment of the Debentures, senior lenders "would be entitled to payment in full before any payment to holders of the Debentures would be permitted." If there were such a default, the Prospectus states, "it is possible that there would be insufficient assets" to pay the Debenture holders and, "so long as a default exists in respect of Senior Debt," payments to Debenture holders "may be prohibited." Further, although the Senior Debt is secured by all of the Company's assets, the Debentures would only be unsecured obligations. (Id.) Finally, the Prospectus points out that the Company is subject to "financial and operating covenants" in the Senior Loan Agreement, and that the Company's failure to comply with those covenants would permit the senior lenders "to accelerate the maturity of the Senior Term Loan or the Revolving Credit Facility, preclude the payment of principal of or interest on the Debentures or both." (Id. at 8.)
B. Description of Senior Loan Agreement
A detailed summary of the Senior Loan Agreement begins at page 38 of the Prospectus. The Agreement itself, the Prospectus explains, is attached as an exhibit to the Registration Statement. Again, investors are reminded that the information contained in the Prospectus is incomplete and is subject to and qualified by the information in that Agreement. The summary contained in the Prospectus does explain that GECC would be paid an agency fee of .25% per annum of the outstanding senior debt balance and that "[a] default rate of interest of 4% above the applicable rate will be charged upon the occurrence and during the continuance of a payment default under the Senior Loan Agreement." (Id. at 38.) The summary explains, again, that the senior debt is secured by a first lien on "substantially all existing or acquired tangible and intangible assets of the Company . . . ." (Id.) It explains, further, that the Senior Loan Agreement requires the Company to maintain particular debt-to-cash-flow and cash-flow-to-fixed-charges ratios that vary over the life of the Agreement. (Id.) If the Company fails to comply with these ratios, the summary states, the senior lenders "may require the Company to sell assets" at fair market values and use the proceeds to pay Senior Debt. Finally, the summary identifies three types of defaults, including (i) failure to make payments on the Senior Loan Agreement, or failure to maintain the financial ratios; (ii) default on other indebtedness, "including the Indenture relating to the Debentures"; and (iii) entry of judgment against the Company or initiation of bankruptcy. (Id. at 39.) Upon the occurrence of such an event of default, the summary states, the senior lenders "may accelerate all amounts due under the Senior Term Loan and Revolving Credit Facility and/or exercise their rights to seize and sell collateral pledged by the Company as security." (Id.)
C. Description of Debentures
Finally, the Prospectus contains a detailed "DESCRIPTION OF DEBENTURES" section, beginning at page 40. In support of their claims that the Prospectus was materially misleading, Plaintiffs focus particularly on this section. Because of their importance to this case, portions of the subsection tilled "Subordination" are quoted at length below. Initially, the subsection reiterates the Debentures' fully subordinated status:
Payment by the Company of the principal amount of and interest on the Debentures will be subordinate to the prior payment in full, in cash or cash equivalents, of all obligations payable in respect of Senior Debt of the Company, whether outstanding at the time of issuance of the Debentures or thereafter created.
Further down the page, however, the Prospectus language appears to distinguish a default in payment on the Senior Debt from other defaults. Thus, with respect to a payment default, the Prospectus states:
The Indenture will provide that no direct or indirect payment may be made by or on behalf of the Company of principal, premium, if any, or interest on the Debentures, whether pursuant to the terms of the Debentures or upon acceleration or otherwise, if at the time of such payment there exists a default in the payment of all or any portion of principal, premium, if any, or interest on, or other amounts due in connection with, any Senior Debt that then ...