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NIELSEN v. GREENWOOD

August 6, 1993

MELVIN C. NIELSEN and PETER C. KOSTANTACOS, Plaintiffs,
v.
DANIEL B. GREENWOOD, JAMES B. KNOLL, CARL GORYCHKA, CARL F. WANGAARD, WILLIAM E. DOTTERWEICH, DONALD K. McKAY, WILLIAM W. ROBERTSON, GREGORY J. ZIOLS, KIDDER, PEABODY & CO., PIPER, JAFFRAY & HOPWOOD, INCORPORATED, SPECIALTY EQUIPMENT COMPANIES, INC., SPE ACQUISITION, INC., and GENERAL ELECTRIC CAPITAL CORPORATION, Defendants.


PALLMEYER, Lindberg


The opinion of the court was delivered by: REBECCA R. PALLMEYER

REPORT AND RECOMMENDATION

Plaintiffs Melvin C. Nielsen and Peter C. Kostantacos ("Plaintiffs") brought this securities fraud class action against Defendants Specialty Equipment Companies, Inc. ("Specialty") and SPE Acquisition, Inc. ("SPE Acquisition"), issuers of subordinated debentures purchased by Plaintiffs; Kidder, Peabody & Co. and Piper, Jaffray & Hopwood, Inc., underwriters of the debentures; General Electric Capital Corporation ("GECC"), senior lender to the issuers; and the officers and directors of Specialty. Defendants Specialty and SPE Acquisition sought bankruptcy protection, and defendant Piper, Jaffray, & Hopwood moved to compel arbitration. The remaining Defendants filed separate motions to dismiss the complaint for failure to state a claim. On February 26, 1993, this court issued a Report and Recommendation ("R&R") recommending that Defendants' motions to dismiss be granted in part and denied in part. The R&R concluded, in part, that Plaintiffs had failed adequately to plead loss causation, an element of a cause of action under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j (b); accordingly, the R&R recommended that Count I of the complaint (Plaintiffs' § 10(b) count) be dismissed. The R&R observed, further, that some courts in this district appear to recognize loss causation as an element of a cause of action under § 12(2) of the Securities Act of 1933, 15 U.S.C. § 77l(2). As none of the parties had briefed the issue, however, this court declined to address the question whether Plaintiffs failure to allege loss causation requires dismissal of Count III (Plaintiffs' § 12(2) count). Upon a Motion for Limited Reconsideration filed with leave of court by Defendants Kidder, Peabody & Co. and the officers of Specialty ("Defendants"), this unaddressed issue is now before the court.

 FACTUAL BACKGROUND

 The facts of this matter are more fully presented in the court's original Report and Recommendation. (R&R, at 2-14.) This Report assumes the reader's familiarity with the earlier R&R and will summarize the relevant facts here only briefly.

 In order to repay the loan that SPE Acquisition had obtained to finance its purchase of Specialty, Specialty issued $ 150 million of subordinated debentures and offered them for sale to the public pursuant to a Prospectus and Registration Statement dated November 15, 1988. (Amended Complaint P 25(a)-(b).) In November 1988 and February 1990, Plaintiffs purchased $ 150,000 of the subordinated debentures. After Specialty suspended payments on the debentures in November 1990, Plaintiffs filed this class action. (Id. PP 6, 30(b).) Plaintiffs alleged, among other things, that Defendants violated the Securities Exchange Acts of 1933 and 1934 (Counts I, II, and III) by misrepresenting powers of the senior lender, GECC, to control the debenture payments. (See id. PP 41-57.)

 The Prospectus issued in conjunction with the debentures describes in detail the subordinated position of the debenture holders in relation to GECC. In the event that Specialty defaulted on a loan payment, the Prospectus allows GECC to suspend the debenture payments indefinitely. In contrast, in the event of a covenant breach -- a breach of Specialty's promise to maintain certain cash-flow ratios -- the Prospectus permits GECC to suspend payment on the debentures for a 120-day period. (Id. P 27.) According to Plaintiffs' reading of the Prospectus, the payments on the debentures should resume after the 120-day period unless there has been further default. (Id.) When Specialty did default on its financial covenant in November 1990, however, GECC exercised a power Plaintiffs contend was not disclosed -- to suspend Specialty's payment of the senior loan, thus causing a payment default. (Id. P 35(b).) In accordance with provisions in the Prospectus for a payment default, GECC was then able to suspend payments on the debentures indefinitely. (Id.) This court's earlier R&R concluded that Plaintiffs had adequately pleaded that the Prospectus was materially misleading because it failed to explain that the senior lenders could, in the event of a covenant default, control Specialty's cash flow and create a payment default.

 Although this court found that Plaintiffs had alleged an adequate basis for a securities fraud claim, the R&R recommended dismissal of Count I (securities fraud claim brought under § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5) based upon Plaintiffs' failure to plead "loss causation." (R&R, at 31.) "Loss causation" refers to the concept -- which the Seventh Circuit has required investors to prove in a § 10(b) action -- that the alleged misrepresentations in the securities offering specifically caused the loss that plaintiff suffered. Bastian v. Petren Resources Corp., 892 F.2d 680, 684 (7th Cir.), cert. denied, 496 U.S. 906, 110 L. Ed. 2d 270, 110 S. Ct. 2590 (1990). As more fully discussed in the earlier R&R, although Plaintiffs established that Defendants made misleading statements in the Prospectus, Plaintiffs failed to plead directly or to allege facts creating an inference that the misrepresentations contained in Defendants' Prospectus caused Plaintiffs' ultimate loss. (R&R, at 27-31.)

 The sole question now before this court is whether Count III -- in which Plaintiffs allege violations of § 12(2) of the Securities Exchange Act of 1933 by the underwriters, Specialty, and the four individuals who signed the Registration Statement and prepared or signed and disseminated the Prospectus -- should also be dismissed for Plaintiffs' failure to allege "loss causation." *fn1"

 DISCUSSION

 Congress passed the Securities Exchange Act of 1933, including § 12(2), to protect investors in securities by requiring sellers "to make full and fair disclosure of the character of securities sold in interstate and foreign commerce. . . ." Pacific Dunlop Holdings Inc. v. Allen & Co., 993 F.2d 578, 581 (7th Cir. 1993) (quoting Wilko v. Swan, 346 U.S. 427, 430-31, 98 L. Ed. 168, 74 S. Ct. 182 (1953)). Specifically, § 12(2) imposes liability on any person who "offers or sells a security . . . by means of a prospectus . . . which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading . . . ." 15 U.S.C. § 77l(2). Thus, § 12(2) is more narrowly focused than § 10(b) of the Securities Exchange Act of 1934, which imposes liability on any person who "uses or employs, in connection with the purchase or sale of any security. . . any manipulative or deceptive device or contrivance. . . ." 15 U.S.C. § 78j(b). Under Section 10(b), plaintiffs must plead that their loss would not have occurred if the facts presented in the offering materials for a securities issue were true, or that defendants' untrue statements caused their loss. See Bastian, 892 F.2d at 684. Defendants here contend that Plaintiffs' failure to plead loss causation requires dismissal of the § 12(2) claim (Count III of the Amended Complaint), as well.

 "Loss Causation" Distinguished from "Transaction Causation"

 The term "loss causation" is commonly confused with "transaction causation," another element which an investor is required to prove under § 10(b) and Rule 10b-5. A plaintiff may establish transaction causation by showing that he would not have engaged in a transaction had the other party made truthful statements at the time required. Loss causation, by contrast, requires an investor to show that he or she would not have suffered a loss if the facts were as he or she believed them to be. LHLC Corp. v. Cluett, Peabody & Co., 842 F.2d 928, 931 (7th Cir.), cert. denied, 488 U.S. 926, 102 L. Ed. 2d 329, 109 S. Ct. 311 (1988), Fujisawa Pharmaceutical Co., Ltd. v. Kapoor, 814 F. Supp. 720, 727 (N.D. Ill. 1993). *fn2"

 At least some authorities cited by Plaintiffs neglect this distinction. For example, Plaintiffs cite Sanders v. John Nuveen & Co., 619 F.2d 1222 (7th Cir. 1980), cert. denied, 450 U.S. 1005, 68 L. Ed. 2d 210, 101 S. Ct. 1719 (1981), a Seventh Circuit case decided before the phrase "loss causation" was widely used in securities law. (Plaintiffs' Opposition, at 2-3.) Sanders was a class action brought by purchasers of short-term promissory notes against the underwriter of the notes. 619 F.2d at 1224. The underwriter failed to make a reasonable investigation of the company that issued the notes, failed to discover that company's true financial status, and, as a result, issued a deceptive prospectus. Id. Defendants argued that there was no showing of causation linking the alleged misrepresentations with the purchases to support a § 12(2) claim because some of the plaintiffs had never received the misleading prospectus. Id. at 1225. Responding to this contention, the court adopted a broad definition of causation under which plaintiffs were allowed to proceed. Alluding to legislative history, the court explained that a misrepresented security will invariably have an over-inflated market price because its price is established with reference to comparable securities on the market. A buyer purchases the security at this false price, whether or not he or she is aware of the representations in the prospectus. Id. at 1226.

 The language of Sanders, in which the court speaks of a "causal connection between the misleading representation or omission and plaintiffs purchase" and analyzes the "offers or sells a security . . . by means of" wording in § 12(2) suggests Sanders was addressing transaction causation and not loss causation. Id. at 1225. Notably, however, Sanders provides an example of a frequently-occurring situation in which the same misrepresentation caused both the transaction and the loss. *fn3" This case differs significantly. Plaintiffs have offered no rationale supporting the notion that, had Defendants disclosed GECC's additional powers in the Prospectus, the market price of the debentures would have changed significantly. Even apart from GECC's allegedly undisclosed power, GECC retained the fully-disclosed power to take near-total control over the debenture payments in the case of a default. Under these circumstances, disclosure of GECC's true total control could not have had a great effect on the value of the debentures. ...


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