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City of Chicago ex rel Scachitti v. Prudential Securities

June 28, 2002

CITY OF CHICAGO EX REL. RAYMOND G. SCACHITTI, PATRICK J. HOULIHAN, AND ROBERT F. RIFKIN, ON BEHALF OF ITSELF AND ALL OTHER MUNICIPAL AND GOVERNMENTAL ENTITIES SIMILARLY SITUATED, PLAINTIFFS-APPELLANTS,
v.
PRUDENTIAL SECURITIES, INC., EVEREN SECURITIES, INC., DELOITTE & TOUCHE, AND ALTSCHULER, MELVOIN & GLASSER L.L.P., DEFENDANTS-APPELLEES.
COUNTY OF DUPAGE EX REL. ADRIANA DIPAOLO, ON BEHALF OF ITSELF AND ALL OTHER MUNICIPAL AND GOVERNMENTAL ENTITIES SIMILARLY SITUATED, PLAINTIFFS-APPELLANTS,
v.
WILLIAM BLAIR & COMPANY, L.L.C., AND DEFENDANT-APPELLEE, AND JERRY L. LACY, DEFENDANT.



APPEAL FROM THE CIRCUIT COURT OF COOK COUNTY. HONORABLE JULIA M. NOWICKI, STEPHEN A. SCHILLER, JUDGES PRESIDING.

The opinion of the court was delivered by: Presiding Justice Campbell

UNPUBLISHED

In appeal number 1-01-0851, plaintiffs Raymond G. Scachitti, Patrick J. Houlihan and Robert F. Rifkin (Scachitti plaintiffs), residents and taxpayers of the City of Chicago (City), filed a lawsuit on behalf of the City against defendants Prudential Securities, Inc. (Prudential), Everen Securities, Inc. (Everen) *fn1 , Deloitte & Touche (Deloitte), and Altschuler, Melvoin, and Glasser, L.L.P. (Altschuler), alleging that all of these defendants breached a fiduciary duty and breached a contract. The Scachitti plaintiffs' complaint also seeks recovery of allegedly fraudulently obtained public funds from Prudential and Everen, pursuant to Article XX of the Illinois Code of Civil Procedure (735 ILCS 5/20-101 et seq. (West 1998)) (Code). The Scachitti Complaint further accuses Prudential and Everen of committing common-law fraud, and Deloitte and Altschuler of malpractice. The Scachitti plaintiffs appeal orders of the circuit court of Cook County dismissing the claim of breach of fiduciary duty for failing to state a claim pursuant to section 2-615 of the Code (735 ILCS 5/2-615 (West 1998)), and dismissing the remaining claims as time-barred, pursuant to section 2-619 of the Code (735 ILCS 5/2-619(a)(5) (West 1998)).

In appeal number 1-01-2111, plaintiff Adriana DiPaolo, a resident and taxpayer of the County of DuPage (County), filed a lawsuit on behalf of the County, making substantially similar claims against William Blair & Co., L.L.C. (Blair) and Jerry L. Lacy. DiPaolo appeals orders of the circuit court of Cook County with respect to Blair, dismissing the claim of breach of fiduciary duty for failing to state a claim, dismissing the Article XX and common-law fraud claims as not alleging the type of injury that those claims could redress, that all of the claims against Blair were time-barred, and finding no just reason to delay enforcement or appeal of the dismissal as to Blair. *fn2 The cases were consolidated on appeal. As a convenience, this opinion refers to Everen, Prudential and Blair collectively as the Underwriter defendants, and to Deloitte and Altschuler collectively as the Accountant defendants.

The record on appeal discloses that both complaints were filed in the trial court on April 3, 2000, and assigned to different judges. Both complaints generally allege that in order to finance public projects, such as roads, schools, hospitals, bridges and the like, local governments borrow money by issuing bonds to investors. Plaintiffs also alleged that, to assist local governments in such efforts, federal law generally exempts interest on such bonds from federal income taxation.

Plaintiffs alleged that the City and County were victims of a practice sometimes called "yield-burning" by underwriters and accountants who handled various aspects of advance-refunding transactions in 1992 and 1993. Plaintiffs' complaints discuss the mechanics of advance-refunding transactions and "yield-burning" at some length. An advance-refunding transaction can result in substantial debt-service savings to issuers in a declining interest-rate environment. Such transactions may be used where the original local governmental bonds paying a high rate of interest cannot be redeemed prior to a specified "call" date in the future.

In an advance-refunding transaction, new local governmental bonds are issued and the proceeds are used to purchase open market securities which are similar or identical to the original bonds in terms of the interest, principal and call date. The open market securities, generally U.S. Treasury obligations, are held in an irrevocable escrow account. This account, also called a defeasance escrow, must be fully invested throughout the defeasance period and used only to pay the interest, principal and redemption premium, if any, on the original refunded bonds.

Plaintiffs allege that federal law does not permit a local governmental issuer to profit from the investment of the proceeds of tax-exempt bonds. Accordingly, plaintiffs allege, federal law restricts the overall yield that local governments can earn on securities placed in a defeasance escrow. If a municipal issuer invests the defeasance escrow in securities that earn a higher yield than that paid to the holders of the advance-refunding bonds, a positive arbitrage would be created; profits from such arbitrage would be required to be paid to the U.S. Treasury at the risk of losing the tax-exempt status of the advance-refunding bonds.

Generally, a municipal issuer must certify that the yield restriction was materially satisfied, along with a statement of the factual basis for the certification. Plaintiffs allege that for advance-refunding bonds, the investment rate of the proceeds cannot exceed the borrowing rate by more than one thousandth of a percentage point. A municipal issuer may satisfy the yield restriction by investing in special State and Local Government Series Bonds (SLGS) from the U.S. Treasury at or below the restricted rate. Alternatively, a municipal issuer may invest in a portfolio comprised of higher yielding open-market securities and zero-interest SLGS that produces a yield at or below the restricted rate.

"Yield burning" may occur where a securities dealer overcharges an issuer for bonds. Because a bond's yield rate moves inversely to the price of the principal, an overcharge decreases the effective yield of the instrument. This practice, colloquially known as "burning" the yield, may also enhance the profits of firms that construct such portfolios for municipal issuers. However, it seems undisputed that U.S. Treasury regulations require defeasance escrow investments to be priced at fair market value, in order to prevent arbitrage.

The Scachitti Complaint alleged that in March 1992, the City issued a $48,070,000 advance-refunding bond series ("1992 City Refunding Bonds") to retire an outstanding 1987 bond issue, on which the City was obligated to pay a higher interest rate than on the 1992 rates. However, the 1987 issue could not be redeemed until January of 1997, so the proceeds from the sale of the 1992 City Refunding Bonds were used to purchase U.S. Treasury Bonds to be held in a defeasance escrow account, which would be used to pay principal and interest, and to redeem the 1987 bonds in 1997.

The Scachitti Complaint avers that Everen served as the lead underwriter for the 1992 City Refunding Bonds. Everen was allegedly hired by negotiation, rather than by competitive bidding. Everen allegedly sold the City U.S. Treasury Bonds that were held in a defeasance escrow. The Scachitti Complaint further alleged that Everen provided various advisory services to the City that rendered Everen an investment adviser to the City, and that a confidential relationship existed between the two, in which the City placed trust and reliance in Everen.

The Scachitti Complaint also alleged that the City retained Deloitte to verify the mathematical accuracy of Everen's yield computations. Plaintiffs allege that Deloitte should have verified the yields according to the fair market value of the escrow securities, and by failing to do so, understated the true yield of the escrow securities, thereby creating a positive arbitrage. The Scachitti Complaint alleges that this knowing oversight permitted Everen to conceal an excessive markup on the bonds and burn the yield by $221,697.06.

Similarly, the Scachitti Complaint alleges that in March 1993, the City issued a $232,880,000 advance-refunding bond series ("1993 City Refunding Bonds") to retire prior outstanding issues. In this transaction, Prudential served as the lead underwriter and is alleged to be in a fiduciary relationship with the City. Like Deloitte, the accounting firm of Altschuler was retained to verify the mathematical accuracy of Prudential's yield computations. The Scachitti Complaint avers that Altschuler should have used the fair market value of the securities in verifying the yield computations, and by knowingly failing to do so, allowed Prudential to conceal $516,554.63 in yield-burned markups.

The DiPaolo Complaint alleges that in April 1993, the County issued a $161,590,000 advance-refunding bond series ("1993 County Refunding Bonds") to retire prior outstanding issues from 1987 and 1991. In this transaction, Blair served as the lead underwriter and is alleged to be in a fiduciary relationship with the County. Lacy was retained to verify the mathematical accuracy of Blair's yield computations. The DiPaolo Complaint claims that Lacy should have used the fair market value of the securities in verifying the yield computations, and by knowingly failing to do so, allowed Blair to conceal at least $707,747 in yield-burned markups.

In both cases, the defendants filed combined motions to dismiss pursuant to section 2-619.1 of the Code (735 ILCS 5/2-619.1 (West 2000)). The arguments raised by the defendants were substantially similar in a number of respects. The motions argued that the Underwriter defendants did not have a fiduciary relationship with the City or the County; the complaints failed to identify the terms of the contracts allegedly breached; and that the City and the County suffered no damages. The motions also argued that the claims against the Underwriter defendants were barred by a five-year statute of repose found in section 13(D) of the Illinois Securities Act (815 ILCS 5/13(D) (West 1992)), and that the claims against the Accountant defendants were barred by the five-year statute of repose for actions brought against public accountants (735 ILCS 5/13-214.2(b) (West 1992)).

In addition, Prudential argued that the Scachitti Complaint's claims against it were barred by a settlement agreement in United States ex rel. Lissack v. Prudential Securities, Inc., 95 Civ. 1363, a suit brought pursuant to the federal False Claims Act in the Federal District Court for the Southern District of New York, involving a number of municipal advance-refunding transactions across the country, including the 1993 City Refunding Bonds. The settlement agreement provided in part that the Internal Revenue Service (IRS) would consider the U.S. Treasury Obligations sold in the transactions listed therein to have been sold at fair market value.

The plaintiffs responded to the various motions to dismiss, arguing in part that the statutes of limitations and repose could not be asserted against the City or County in the performance of public acts under the doctrine of nullum tempus occurrit regi ("time does not run against the king"). The plaintiffs also argued that if a statute of limitations was applicable, the Article XX claims would be governed by section 13-205 of the Code (735 ILCS 5/13-205 (West 2000)) and the time for brining them would be tolled due to fraudulent concealment; the complaints properly pleaded that the City and County suffered damages; and that the breach of contract and fiduciary duty claims were properly pleaded. In addition, the Scachitti plaintiffs argued that the City's interests were not represented in the settlement of the federal lawsuit.

On September 26, 2000, the trial court dismissed the DiPaolo Complaint's claim of breach of fiduciary duty for failure to state a claim. The trial court's order also dismissed the DiPaolo Complaint's Article XX and common-law fraud claims on the ground that they did not allege the type of injury these claims could redress; the order granted DiPaolo leave to replead as to these later claims. The transcript of proceedings shows that the trial court also ruled that the nullum tempus doctrine did not insulate the DiPaolo complaint against a statute of limitations, which the trial court determined to be section 13-205 of the Code.

On January 31, 2001, the trial court issued a memorandum and opinion as to the Scachitti Complaint. The order states that the trial court had previously ruled during hearings on the motions to dismiss that: the nullum tempus doctrine did not apply to the claims at issue; the five-year statute of repose found in section 13(D) of the Illinois Securities Act could not be tolled by allegations of fraudulent concealment; that the motion to dismiss claims of breach of fiduciary duty for failure to state a claim was granted as to all defendants; and Accountant defendants' motions to dismiss based on the five-year statute of repose for actions brought against public accountants was granted. The order then discussed section 13(D) of the Illinois Securities Act, concluding that it applied to and barred the Article XX and breach of contract claims.

On May 10, 2001, after DiPaolo amended her complaint, the trial court entered an order ruling that the claims against Blair were barred by section 13(D) of the Illinois Securities Act, and finding no just reason to delay enforcement or appeal of the dismissal as to Blair. The plaintiffs filed Notices of Appeal to this court, which consolidated the cases for appeal.

I.

The issue on appeal in both cases is whether the trial court erred in dismissing plaintiffs' complaints. The complaints were dismissed pursuant to section 2-619 of the Illinois Code of Civil Procedure, which provides a means of obtaining summary disposition of issues of law or easily proved issues of fact. Kedzie & 103rd Currency Exchange, Inc. v. Hodge, 156 Ill. 2d 112, 115, 619 N.E.2d 732, 735 (1993). Section 2-619(a)(5) provides that an action may dismissed where it "was not commenced within the time authorized by law." 735 ILCS 5/2-619(a)(5) (West 2000). A section 2-619 motion to dismiss admits the legal sufficiency of the plaintiffs' cause of action, much as a section 2-615 motion to dismiss admits a complaint's well-pleaded ...


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