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August 6, 1993



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


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.


 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"


 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. Although Sanders presents a broad interpretation of causation that would support Plaintiffs' claim, the fact pattern to which the supporting analysis applies is significantly different from that of the present case and, thus, provides little support for either party here.

 Case Law in this Circuit and District

 The parties disagree over whether case law from this circuit requires a plaintiff to plead "loss causation" as an element of his cause of action under § 12(2). Defendants rely on the same cases cited by this court in its earlier R&R. Plaintiffs point out, however, that those decisions from this circuit that do suggest that loss causation is a pleading requirement for a § 12(2) claim provide no extensive explanation for that conclusion. In Robin v. Falbo, No. 91 C 2894, 1992 WL 188429 (N.D. Ill. July 24, 1992), for example, plaintiffs sued defendant real estate developer under § 10(b), Rule 10b-5, and § 12(2) of the federal securities laws, alleging that defendant induced them to buy securities by means of misleading statements about the financial condition of the development partnership. Some time after the original purchase, the development partnership began operating at a loss and plaintiffs' securities dropped in value. Id. at *1. Plaintiffs alleged that the misrepresentations caused them to enter the transaction, but failed to allege that the misrepresentations caused their loss. The court stated that plaintiff needed to allege both loss causation and transaction causation for claims under § 10(b) and Rule 10b-5, and then went on to apply this requirement to § 12(2) without any explanation or recognition of the differences between the two sections. Id. at *1-2.

 In Xerox Fin. Servs. Life Ins. Co. v. Salomon Bros., Inc., No. 92 C 1767, 1992 WL 151923 (N.D. Ill. June 18, 1992), similarly, the court offered little explanation in requiring plaintiffs to plead loss causation as part of their § 12(2) claim. Plaintiffs in Xerox had invested in an economy-hotel company that eventually went into debt. Id. at *1. After their investment went bad, plaintiffs brought suit against the issuer of the securities, charging that it had misrepresented the declining financial status of the company and the fee arrangements between the company and the issuer. Id. at *2. Plaintiffs did not allege loss causation. Citing only to 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), the court stated that plaintiffs were required to allege loss causation as part of a § 12(2) claim. 1992 WL 151923, at *6.

 The Bastian decision does not support a requirement of loss causation under § 12(2), however. In Bastian, in fact, the Seventh Circuit specifically recognized that § 12(2) differs from § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, for which loss causation is a necessary element:


If the plaintiffs would have lost their investment regardless of the fraud, any award of damages to them [under § 10(b)] would be a windfall. Other sections of the securities laws, such as section 12(2) of the 1933 Act, 15 U.S.C. § 77l, permit windfall recoveries, . . . . Proof of loss causation has been held to be required in some actions under section 12(2), Wilson v. Ruffa & Hanover, P.C., supra, 844 F.2d at 85-86, . . . .

 892 F.2d at 684-85 (emphasis added). Thus, the Bastian court observed, if defendants' misrepresentation did not cause plaintiffs' loss, then to award plaintiffs damages under § 10(b) would be a windfall. But § 12(2) permits windfall recovery -- it permits a plaintiff to recover without any showing of loss causation.

 The Bastian court cited to Wilson v. Ruffa & Hanover, P.C., 844 F.2d 81 (2d Cir. 1988), vacated on reargument, sub nom. Wilson v. Saintine Exploration & Drilling Corp., 872 F.2d 1124 (2d Cir. 1989), as support for the notion that loss causation may be required in some § 12(2) cases. In Wilson v. Ruffa, the Second Circuit held that while loss causation is not required when defendants directly sell securities, it is required when defendants are nonselling collateral participants in a securities transaction. 844 F.2d at 86. In that case, defendant law firm prepared and delivered a misleading prospectus, but did not sell or underwrite the securities in question. Id. at 82-83. The Second Circuit held that plaintiff was required to show loss causation to support a § 12(2) claim because defendant was a collateral participant rather than a direct seller. Id. at 86.

 As Plaintiffs here point out (Plaintiffs' Opposition, at 4 n.2), the Second Circuit subsequently reconsidered its Wilson decision in light of the Supreme Court's opinion in Pinter v. Dahl, 486 U.S. 622, 100 L. Ed. 2d 658, 108 S. Ct. 2063 (1988). *fn4" On reconsideration, the Second Circuit reached the same result, but abandoned the nonselling collateral participant/direct seller distinction respecting the loss causation pleading requirement. Following Pinter, the Second Circuit concluded that § 12(2) only applied, without a need to show loss causation, to direct sellers -- collateral participants were not liable for § 12(2) violations at all. Wilson v. Saintine, 872 F.2d at 1126-27. The Second Circuit held that defendant law firm could not be held liable under § 12(2) because the law firm did not solicit the sale of the securities. Id. at 1127. In the present case, Defendants are direct sellers. *fn5" The Second Circuit analysis (cited with approval in Bastian) thus suggests that an allegation of loss causation should not be required for a § 12(2) claim.

 The court in Scholes v. Schroeder, 744 F. Supp. 1419, 1423-24 (N.D. Ill. 1990), also relied on the Bastian decision. Scholes is also distinguishable, however, because it involved a § 12(2) suit brought by the court-appointed receiver of a securities dealer against other sellers who allegedly participated with the dealer in his fraud. Id. at 1420. Scholes claimed that the receivership entities he represented had sold the securities in reliance on misrepresentations made by defendants, the other sellers. Recognizing that defendants' wrongdoing had actually enriched the receivership estates, the court dismissed Scholes' § 12(2) claim, explaining that "it is incumbent on Scholes to explain how the seller of securities can make such a 1933 Act § 12(2) claim . . . in light of the principles of loss causation stated in Bastian v. Petren Resources Corp." Id. at 1423-24 (citations omitted). Because this was a unique situation of a seller (through its receiver) bringing suit instead of a buyer, the court directed that Scholes address and explain his standing to seek recovery against others with whom the architect of the fraud structure had conspired. The Scholes court did not specifically hold that loss causation is a requirement of § 12(2), and does not weigh in favor of or against including loss causation in a § 12(2) claim.

 Defendants correctly assert that the support for Plaintiffs' position provided by Pommer v. Medtest Corp., 961 F.2d 620 (7th Cir. 1992), is dicta. (Defendants' Reply, at 4-5.) Plaintiffs in Pommer brought a fraud claim under § 10(b) and Rule 10b-5, not under § 12(2). 961 F.2d at 622. Pommer does suggest a rationale supporting Plaintiffs' position, however. In discussing damages under the federal securities acts, the Pommer court observed that while § 12(2) uses the same starting point for damages as does § 10(b), it "also allows the defendant to reduce the award by demonstrating that the misstatement did not cause the decline in value." Id. at 628 (emphasis added). By recognizing that a plaintiff may recover some damages even if the misstatement was not the cause of loss, the court implies that plaintiff may have a cause of action even without loss causation. Id.; see also Ackerman v. Schwartz, 947 F.2d 841, 845 (7th Cir. 1991) (distinguishing § 12 claims from other securities fraud claims and noting that "missing [in § 12] is any reference to causation and contribution".) Further, at least one court in this district has expressly distinguished § 12(2) from § 10(b) as not requiring a showing of loss causation. Coe v. Nat'l Safety Assocs., Inc., 131 F.R.D. 252, 254 (N.D. Ill. 1991).

 Defendants here argue that a plaintiff who shows no loss causation under Pommer will have no claim because the damages would be mitigated to nothing. (Defendants' Reply, at 5.) That argument addresses only the issue of damages, however, a matter quite distinct from that of liability. Pommer thus does lend support for the argument that there may be liability under § 12(2) without loss causation and that the absence of loss causation will be relevant only to the damages award.

 Case Law in Other Circuits

 Addressing the question more directly, courts in two other circuits have held that a plaintiff is not required to plead loss causation in order to state a claim under § 12(2): "Statutory sellers 'may now be liable under section 12 whether or not scienter or loss causation is shown.'" Polycast Technology Corp. v. Uniroyal, Inc., 792 F. Supp. 244, 259 (S.D.N.Y. 1992) (quoting Wilson v. Saintine Exploration and Drilling Corp., 872 F.2d 1124, 1126 (2d Cir. 1989)). More recently, the Fourth Circuit held that neither loss causation nor transaction causation is a required element of a claim under § 12(2): "A claim under § 12(2) may be grounded on untrue statements and omissions that make a memorandum misleading, whether or not the plaintiff relied on the memorandum or even read it, and may justify rescission, whether or not the plaintiff was damaged." Caviness v. Derand Resources Corp., 983 F.2d 1295, 1305 (4th Cir. 1993). In Caviness, plaintiffs invested in oil and gas wells managed by defendants. Id. at 1298. Dissatisfied with the returns on their investment and seeking rescission, plaintiffs claimed that defendants' private placement memoranda on which they relied to make their investment decisions were misleading because of untrue statements and omissions. Id. at 1298-99, 1304. The court held that plaintiffs had stated a valid claim for rescission of a sale of a security under § 12(2), even though plaintiffs' complaint made no allegation that the misleading statements caused their loss. Id. at 1305.

 Authority from outside this Circuit thus suggests that Plaintiff may challenge the deceptive statements in the Prospectus, even without demonstrating that the misstatements caused their loss. *fn6"

 Policy Considerations

 Defendants raise some policy arguments in support of their position that § 12(2) requires a showing of loss causation. They urge that § 12(2) was not intended to provide investors with an "insurance policy against nonspecific risks and losses." (Defendants' Reply, at 2-3.) As the Supreme Court has recognized, however, while Congress certainly did not enact the Securities Exchange Act of 1933 as an insurance policy, the Act may have precisely this incidental effect in its legitimate application:


We may therefore infer that Congress chose a rescissory remedy when it enacted § 12(2) in order to deter prospectus fraud and encourage full disclosure as well as to make investors whole. Indeed, by enabling the victims of prospectus fraud to demand rescission upon tender of the security, Congress shifted the risk of an intervening decline in the value of the security to defendants, whether or not that decline was actually caused by the fraud.

 Randall v. Loftsgaarden, 478 U.S. 647, 659, 92 L. Ed. 2d 525, 106 S. Ct. 3143 (1986). *fn7" The Second Circuit echoes this interpretation: "In drafting Section 12(2), Congress obviously sought to provide a heightened deterrent against sellers who make misrepresentations, by rendering tainted transactions voidable at the option of the defrauded purchaser regardless of whether the loss is due to the fraud or to a general market decline." Wilson v. Ruffa, 844 F.2d at 86.

 By providing a heightened deterrent, Section 12(2) may appear to function as an "insurance policy," but such an appearance is incidental to the legitimate goal of deterring misrepresentations. Another related incidental effect of this heightened deterrent is that windfall awards may be bestowed upon plaintiffs whose loss was not caused by defendants' misrepresentations; as the Seventh Circuit has already recognized, however, such windfalls may be a permissible result under § 12(2). See Bastian, 892 F.2d at 685. The fact that Plaintiffs' securities underwent a severe decline in market value not caused by the misrepresentation itself need not preclude an award of damages under § 12(2).

 Defendants suggest that the purpose of § 12(2), "to prevent the price of a security from being artificially inflated through mis representations affecting the value the public would place on the security," is not undermined by the omission of loss causation as an element. (Defendants' Reply, at 2.) Omission of that requirement does, however, permit plaintiffs to challenge misrepresentation even without establishing a causal link that may be difficult or impossible to prove. The heightened deterrent provided by this standard thus will induce sellers to be more careful in representing the security -- a measure that will, over time, reduce the number of artificially inflated securities. *fn8"

 Finally, Defendants argue that the imposition of a loss causation requirement for § 12(2) claims would prevent abusive lawsuits in which defendants are harassed or forced into settlement. (Defendants' Reply, at 3.) That argument loses sight of the purpose of § 12(2). Even without a loss causation requirement, a plaintiff must still prove that the defendant made a false representation in order to proceed under this section. Thus, a seller can avoid an abusive lawsuit with a carefully drafted prospectus -- precisely what the heightened deterrent of § 12(2) is intended to induce. The policy considerations articulated by Defendants do not require that this court read a loss causation element into § 12(2).


 The weight of authority supports a conclusion that loss causation is not an element which must be pleaded and proved by Plaintiffs under § 12(2). Although Seventh Circuit case law is inconclusive, other circuits (including one Second Circuit case cited with approval by our Court of Appeals) have directly addressed the issue and found "loss causation" to be unnecessary. In enacting § 12(2), Congress evidently intended to provide extra protection to investors against false statements. Such protection is enhanced by a determination that a plaintiff may proceed under § 12(2) even without a specific showing that the challenged statement actually caused his or her loss. Thus, after limited reconsideration, this court again recommends that Defendants' Motion to Dismiss Count III be denied.



 United States Magistrate Judge

 Date: August 6, 1993

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