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ONG v. SEARS

September 24, 2004.

THOMAS G. ONG for THOMAS G. ONG IRA and THOMAS G. ONG, individually and on behalf of all others similarly situated, Plaintiffs,
v.
SEARS, ROEBUCK & CO., SEARS, ROEBUCK ACCEPTANCE CORP., ALAN LACY, PAUL J. LISKA, GLENN R. RICHTER, KEVIN T. KELEGHAN, K.R. VISHWANATH, KEITH E. TROST, GEORGE F. SLOOK, LARRY R. RAYMOND, THOMAS E. BERGMANN, CREDIT SUISSE FIRST BOSTON, GOLDMAN, SACHS & CO., MORGAN STANLEY, BEAR, STEARNS & CO., INC., LEHMAN BROTHERS and MERRILL LYNCH & CO., INC., Defendants.



The opinion of the court was delivered by: REBECCA PALLMEYER, District Judge

MEMORANDUM OPINION AND ORDER

Plaintiffs Thomas G. Ong and Thomas G. Ong IRA have filed this federal securities class action lawsuit on behalf of (1) all those who purchased, pursuant to a prospectus, securities issued by defendant Sears, Roebuck Acceptance Corp. ("SRAC"), a wholly-owned subsidiary of Defendant Sears, Roebuck & Co. ("Sears"), between October 24, 2001 and October 17, 2002 (the "Class Period"), in any of three debt securities offerings dated March 18, May 21, and June 21, 2002, and (2) all those who, during the Class Period, purchased publicly traded securities issued by SRAC before the Class Period and actively traded them through the public markets and over national securities exchanges.

Sears is one of North America's largest general retailers. In addition to its retail division, Sears provides financing to its customers through private label credit cards and installment plans. SRAC's principal business is purchasing Sears' short-term notes and account receivable balances, which it finances through public sales of SRAC Notes. Defendants Alan Lacy, Glenn R. Richter, Paul J. Liska, Keith E. Trost, George F. Slook, Larry R. Raymond, Thomas E. Bergmann, Kevin T. Keleghan, and K.R. Vishwanath were all officers or directors of Sears, SRAC, or both. Defendants Credit Suisse First Boston Corporation ("CSFB"), Goldman, Sachs & Co. ("Goldman Sachs"), Morgan Stanley & Co., Inc. ("Morgan Stanley"), Bear, Stearns & Co., Inc. ("Bear Stearns"), Lehman Brothers Inc. ("Lehman Brothers"), and Merrill Lynch & Co., Inc. ("Merrill Lynch") were all underwriters of the three SRAC debt securities offerings at issue in this case.

  Plaintiffs allege that Sears manipulated information regarding its credit card operations to make them appear "more stable and profitable than they actually were," which artificially inflated the market value of SRAC debt securities. Specifically, Sears misrepresented its reliance on subprime creditors; selectively reported delinquency and charge-off rates; and disguised portfolio losses in order to generate high levels of reported receivables that Sears knew would prove uncollectible. Plaintiffs claim that Defendants all made materially false and misleading statements or omissions in connection with Sears' credit card operations in violation of §§ 11, 12(a)(2), and 15 of the Securities Act of 1933, 15 U.S.C. §§ 77k, 77l(a)(2), and 77o; and §§ 10(b) and 20(a) of the Securities Exchange Act of 1934 ("SEA"), 15 U.S.C. § 78j(b) and 78t(a), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5.

  Defendants move to dismiss Plaintiffs' complaint for failure to comply with the pleading requirements of FED. R. CIV. P. 9(b) and the PSLRA, and for failure to state a claim. For the reasons set forth here, the motion to dismiss filed by CSFB, Goldman Sachs, Morgan Stanley, Bear Stearns, Lehman Brothers, and Merrill Lynch (collectively, the "Underwriter Defendants") is denied. The motion to dismiss filed by Sears, SRAC, Mr. Lacy, Mr. Liska, Mr. Richter, Mr. Trost, Mr. Slook, Mr. Raymond, and Mr. Bergmann (collectively, the "Sears Defendants") is granted in part and denied in part. The motions to dismiss filed by Mr. Keleghan and Mr. Vishwanath are also granted in part and denied in part.

  BACKGROUND

  Sears, a New York corporation with its principal executive offices in Hoffman Estates, Illinois, is one of the largest general retailers in North America. As part of its operations, Sears provides financing to customers through private label credit cards and installment plans. SRAC, Sears' wholly-owned subsidiary, is primarily in the business of purchasing short-term notes or receivable balances from Sears. SRAC funds these purchases by issuing debt securities such as commercial paper, medium term notes, and "other borrowings" (collectively, "SRAC Debt Securities") to the public. (Cmplt. ¶¶ 11, 12, 46, 47.)*fn1 Three SRAC Debt Securities offerings are at issue in this case: (1) $600 million of 6.70% notes due April 15, 2012, offered pursuant to an Indenture dated May 15, 1995 (the "Indenture"), a Registration Statement and accompanying Prospectus dated September 3, 1998 (the "Registration Statement"), and a Prospectus and Prospectus Supplement dated March 18, 2002 (the "3/18/02 Offering"); (2) $1 billion of 7.0% notes due June 1, 2032, offered pursuant to the Indenture, the Registration Statement, and a Prospectus and Prospectus Supplement dated May 21, 2002 (the "5/21/02 Offering"); and (3) $250 million of 7.0% notes due July 15, 2042, offered pursuant to the Indenture, the Registration Statement, and a Prospectus and Prospectus Supplement dated June 21, 2002 (the "6/21/02 Offering"). (Id. ¶ 2.)

  Mr. Lacy was Sears' Chief Executive Officer, President, and Chairman of the Board throughout the Class Period. Mr. Richter has been Sears' Chief Financial Officer since October 4, 2002 and also served as Sears' Senior Vice President, Finance prior to that date. Mr. Liska was Sears' Chief Financial Officer until Mr. Richter took over in October 2002. He also served as a director of SRAC. Mr. Trost was the President of SRAC as well as a director of the company. Mr. Slook, also a director of SRAC, was SRAC's Vice President of Finance. Mr. Raymond served as a director of SRAC, as did Mr. Bergmann, who was also Chief Accounting Officer and Controller of Sears. Mr. Keleghan was President of Sears' Credit and Financial Products segment and "an Executive Vice President from the start of the Class Period until October 4, 2002, when he was forced to resign." Mr. Vishwanath was Sears' Vice President of Risk Management until the company terminated his employment on October 16, 2002. (Id. ¶¶ 13-21.)

  CSFB, Goldman Sachs, Morgan Stanley, Bear Stearns, Lehman Brothers, and Merrill Lynch are all integrated financial services institutions that provide securities, investment management, and credit services to corporations, governments, financial institutions, and individuals. CSFB and Goldman Sachs were joint "book runners" — i.e., managing underwriters — for the 3/18/02 Offering of SRAC Debt Securities. Morgan Stanley, Bear Stearns, and Lehman Brothers were all joint lead managers for the 5/21/02 Offering. Morgan Stanley was also the book runner for that offering. Merrill Lynch was the book runner for the 6/21/02 Offering. (Id. ¶¶ 32-37.)

  A. The Relationship Between Sears and SRAC

  SRAC's operating income is generated primarily from the earnings on its investments in Sears' short-term notes and account receivables. In addition, Sears determined the amount of SRAC's earnings by requiring SRAC to maintain a set ratio of earnings to fixed expenses. "As a result, the yield on SRAC's investment in Sears notes is directly related to SRAC's borrowing costs, i.e., the yield under which SRAC can issue and sell its Debt Securities." It is in Sears' financial interest to keep SRAC's borrowing costs as low as possible because the less SRAC must pay purchasers of its Debt Securities, the less Sears must pay to borrow from SRAC. (Id. ¶ 48.)

  Given the inter-relationship between Sears and SRAC, "industry analysts and the rest of the market looked to the finances, financial condition and present and future operations of Sears when assessing the investment prospects for SRAC Debt Securities." (Id. ¶ 49.) When industry analysts viewed Sears favorably, SRAC was viewed favorably as well; when Sears experienced a downward change in its financial condition, SRAC's financial condition suffered as well. (Id. ¶¶ 50-53, 57-59.) According to Plaintiffs, "the intertwining of the finances and operations of SRAC and Sears cause the SRAC Debt Securities to take on the status of a direct investment with Sears itself." (Id. ¶ 54.)

  B. Sears' Credit Problems

  For many years, Sears was one of the largest credit card issuers in the country. (Id. ¶ 60.) Prior to 1993, Sears only accepted its own proprietary credit cards ("Sears Cards") which could only be used to make purchases at Sears. (Id. ¶ 61.) When Sears began accepting general credit cards in 1993, the company saw a drastic decrease in the use of its Sears Cards; indeed, by mid-2000, nearly half of the 60 million Sears Cards were either inactive or carried a zero balance. (Id.) At the same time, Sears' retail sales were also in decline due to increased competition from discount retailers like Wal-Mart and Kohl's. (Id. ¶ 62.)

  In late 2000, Sears began to issue a Sears MasterCard, a general purpose credit card that could be used wherever MasterCard was accepted. The cards carried higher lines of credit and generated fee income for Sears when used at non-Sears locations. Sears hoped that the Sears MasterCard would "stimulate sales and help regain income Sears had lost in recent years due to the decline of its proprietary cards." (Id. ¶ 64.) In November 2000, Mr. Lacy, who had been named President and CEO of Sears just a month earlier, emphasized the Sears MasterCard as a top area for growth within the company. (Id. ¶ 65.)

  By February 2001, the Sears MasterCard carried $1.4 billion in receivables and Sears, through its subsidiary Sears National Bank, had become one of the top 25 bank card issuers. A February 15, 2001 article in American Banker indicated that Mr. Keleghan, President of Sears Credit, had described Sears MasterCard users as "a very pristine group, almost too pristine . . . We don't expect significant delinquencies since we're starting out with a low-risk group." (Id. ¶ 67.) Sears' retail segment continued to decline over the next several months, but Mr. Lacy asserted at an April 19, 2001 analyst presentation that Sears' credit segment had "a strong portfolio quality overall" and was "a great business" and "strategically very important" to Sears. (Id. ¶¶ 68, 69.)

  Despite these representations, Sears credit operations actually suffered from several weaknesses and problems which were hidden from the market. Those weaknesses, described below, ultimately led to an announcement that Sears planned to sell the credit business. (Id. ¶¶ 70, 71.)

  1. Reliance on Subprime Creditors

  During the Class Period, Sears aggressively marketed its credit cards, particularly the Sears MasterCard, to "create the appearance of a growing, profitable loan portfolio." (Id. ¶ 72.) To that end, Sears intentionally lowered its acceptable credit profile so that more consumers would qualify for credit cards, and adopted aggressive marketing strategies designed to appeal to low-income or unstable borrowers, such as unsolicited direct mailings, free balance transfers, and convenience checks.*fn2 Sears also offered multiple credit cards and increased credit limits to customers who did not qualify for such benefits. (Id.) At the beginning of the Class Period, approximately 54% of Sears' credit portfolio consisted of subprime creditors, compared with a United States industry average of 36.6%. By the end of the Class Period, the portfolio was still nearly half subprime. (Id. ¶¶ 73, 74.)

  2. Selective Reporting Techniques

  In addition to targeting subprime creditors, Sears misleadingly reported the charge-off and delinquency rates*fn3 of its credit cards on a portfolio-wide basis rather than separating out the performances of the Sears Card and the Sears MasterCard. The Sears MasterCard had higher credit limits than those traditionally offered under the Sears Card, as well as lower delinquency and charge-off rates. According to the Plaintiffs, "[t]hese factors, when combined with the dramatic increases in MasterCard receivables, declining Sears proprietary card receivables, [and] the fact that the Sears proprietary card portfolio was much larger than the new MasterCard portfolio, created an interesting phenomenon during the Class Period." Specifically, though both portfolios were separately experiencing a "striking rise in delinquencies and charge-offs every quarter," the combined portfolios reflected delinquencies and charge-offs that were relatively stable "because the Sears Card receivables overweighted the average of the two groups." (Id. ¶¶ 76-78.)

  3. Disguised Losses

  Plaintiffs allege that Sears also engaged in practices designed to disguise losses to its credit portfolio. Sears National Bank, which Sears created in 1995, is not subject to the same rules and regulatory oversight as ordinary bank card issuers.*fn4 Thus, Sears was able to adopt more lenient credit policies than its competitors. (Id. ¶ 80.) For example, Sears charged-off delinquent credit card loans after 240 days compared with 180 days by competitors. (Id. ¶ 80(a).) Sears also deferred charge-offs by relying on generous "renewal" policies, such as offering to make a delinquent account "current" if a customer made a single, minimum payment, and then closing the account and implementing an installment plan to collect the balance due. In addition, Sears "cured" or "re-aged" delinquent accounts (i.e., converted them to current status) after receiving only two consecutive minimum payments; federal regulations require three consecutive minimum payments prior to re-aging. (Id. ¶ 80(b)-(c).)

  Sears also adopted promotional programs, such as zero percent financing, that allowed cardholders to minimize or avoid payments for periods of up to a year. This made it "difficult, or even impossible, for cardholders to fall behind in their payments and allowed Sears to delay reporting such accounts as delinquent." (Id. ¶ 80(d).) In addition, Sears repeatedly lowered the required minimum monthly payments, which allowed individuals with poor credit histories to purchase higher priced items on more extended payment schedules. This practice increased Sears' income from finance charges but also increased its exposure to bad debt. (Id. ¶ 80(e).) Finally, though it is industry practice to report delinquencies after 30 days, Sears did not report them until after 60 days. (Id. ¶ 80(f).) According to Plaintiffs, these policies misled investors as to the true quality of Sears' credit portfolio. (Id. ¶ 81.)

  4. Fraudulent Billings

  A final practice that served to weaken Sears' credit portfolio was fraudulent billings on customer accounts. Sears strongly encouraged its employees to induce customers to purchase additional services, including life insurance, credit protection, and extended warranties, whenever they bought a Sears product. "The incentives to make such sales were so strong that it became a regular practice for salespersons to put such items on customers' accounts without their knowledge or consent." (Id. ¶ 82.) This, in turn, "helped drive up the high levels of reported receivables that Sears knew to be uncollectible." (Id.)

  C. False and Misleading Statements

  Plaintiffs allege that Defendants issued numerous false and misleading statements to deceive the investing public into believing that Sears' credit operations were "far better, more successful and profitable, than was actually the case." (Id. ¶ 83.)

  1. Third Quarter 2001 On October 24, 2001, Sears issued a press release, filed as an SEC Form 8-K signed by Mr. Richter, announcing its results for the third quarter of 2001. Sears reported that earnings had increased by 5.3% per share over the prior year despite a decline in retail revenues. With respect to Sears Credit, the press release indicated that customer bankruptcy filings had declined from the second to third quarter of 2001 and that delinquencies were down from 7.47% to 7.41% over the previous year. (Id. ¶ 84.) At an analysts meeting the same day, Mr. Liska stated that "our delinquencies are actually going down. That's why we're feeling good about our portfolio." (Id. ¶ 86.) He also assured investors that Sears' "watch rate*fn5 of 5.76% was ahead of MBNA and Banc One and significantly better than Capital One or Discover," and that "our 60 day delinquency rates or trends remain very stable." (Id. ¶ 87.) Mr. Liska stated that based on the stability of the credit portfolio quality, "we continue to still believe that it is very adequately and conservatively reserved in the current environment." (Id. ¶ 88.)

  At the same analysts meeting, Mr. Keleghan stated that Sears was targeting "the best credit risk customers and the customers with the most profit potential to drive sales in the store." According to Mr. Keleghan, Sears was "bringing much more of that upper class customer who is lower risk" and "continually improv[ing] the quality of the accounts that we've booked." Mr. Keleghan confirmed Mr. Liska's representation that the credit portfolio was of high quality, stating that "the delinquency rate of these customers is a very pristine group." Mr. Keleghan also assured investors that Sears was monitoring the credit card portfolio on a daily basis to identify any problem accounts and manage outstanding credit risks. (Id. ¶¶ 88-90.) In response to questions about Providian, a subprime credit card lender, Mr. Keleghan stated that "[w]e don't target the subprime market, we avoid it and we try to target the middle market." (Id. ¶ 92.) On November 9, 2001, Sears filed a Form 10-Q, signed by Mr. Richter, reiterating its third quarter results as stated in the October 24, 2001 Form 8-K. Sears reported that "our delinquencies are actually going down" and that "our portfolio quality has continually improved." In fact, though the combined portfolio appeared stable, charge-off and delinquency rates for both the Sears Card and Sears MasterCard had risen over the prior quarter. Sears Card charge-offs rose to 6.03%*fn6 and Sears MasterCard charge-offs rose from .90% to 2.02% between the second and third quarter of 2001. Similarly, Sears Card delinquencies rose to 8.13%*fn7 and Sears MasterCard delinquencies rose from 1.20% to 1.93% from the second to third quarters of 2001. (Id. ¶¶ 93, 94.) A few weeks later on November 26, 2001, Mr. Liska held another conference call with analysts and again represented that Sears' portfolio was "adequately reserved." (Id. ¶ 95.)

  2. Fourth Quarter 2001

  On January 10, 2002, Sears issued a press release, filed as an SEC Form 8-K and signed by Mr. Liska, announcing preliminary results for the fourth quarter of 2001. The press release stated that earnings per share for the full year 2001 would be approximately $4.22, "essentially flat with comparable 2000 earnings per share of $4.21." The press release further assured that "portfolio quality remains solid, with delinquency levels flat compared to the prior year period." (Id. ¶ 96.) A week later on January 17, 2002, Sears issued another press release, also filed with the SEC, stating that the portfolio delinquency rate for the fourth quarter of 2001 was 7.58% compared with 7.56% for the fourth quarter of 2000. The press release indicated that "[p]ortfolio quality remains stable with flat year-over-year delinquencies. The domestic allowance for uncollectible accounts of $1.1 billion is flat as a percentage of ending credit receivables." (Id. ¶ 97.) The press release further reported that Sears Credit generated $1.5 billion of Sears' $2.202 billion in operating income for 2001, even though Sears Credit accounted for only 12.6% of Sears' revenues. (Id. ¶ 98.)

  Also on January 17, 2002, Sears held a conference call with investors to discuss the fourth quarter 2001 results. Mr. Lacy told investors that "[i]mportantly, the quality of our receivables portfolio has remained strong and our outlook is stable looking into 2002." Mr. Liska elaborated that "[t]he provision for uncollectible accounts increased by $52M in the quarter to $391M. The provision reflects a $26M addition to the allowance . . . The addition to the reserve was made to reflect growth in receivables and not because of concern about portfolio quality." Mr. Liska noted that Sears expected charge-off rates to remain "roughly flat with 2001 with stable credit quality in the portfolio." (Id. ¶¶ 99, 100; Transcript of Analyst Conference Call of 1/17/02, Ex. N to Sears Mem.)*fn8

  In its SEC filings, Sears reported that delinquencies had remained "flat" and that charge-offs had increased only 9% over the past year, from 4.79% at year-end 2000 to 5.23% at year-end 2001. These figures were presumably based on the portfolio as a whole. Viewed separately, however, Sears Card delinquencies had increased by 12% from 7.94% in the fourth quarter of 2000 to 8.91% in the fourth quarter of 2001. Sears Card charge-offs had also increased 20% over the previous year from 4.79% to 5.78%. Sears MasterCard similarly showed an increase in delinquencies from .38% at year-end 2000 to 1.97% in the fourth quarter of 2001. MasterCard charge-offs increased from 2.02% in the third quarter of 2001 to 2.09% in the fourth quarter of that year. (Id. ¶ 102.)

  3. First Quarter 2002 UBS Warburg is the global investment banking division of wealth management company UBS AG; UBS Warburg provides corporate, institutional, government, and private clients worldwide with debt and equity finance, advisory services, research, risk management, and securities and foreign exchange. See Nikko Asset Mgmt. Co. v. UBS AG, 303 F. Supp. 2d 456, 458 (S.D.N.Y. 2004); http://www.ubs.com. On March 7, 2002, UBS Warburg issued a report discussing Sears' credit card business. Based on a conversation between a UBS Warburg representative and Mr. Keleghan, the report indicated that Sears' "management seems focused on employing a prudent and risk averse growth strategy." (Cmplt. ¶ 103.) One week later, on March 14, 2002, Sears filed its Form 10-K for 2001, which was signed by Mr. Lacy, Mr. Liska, and Mr. Bergmann. The Form 10-K repeated the financial information contained in the January 17, 2002 Form 8-K, and acknowledged that charge-offs had increased by $446 million "primarily due to increased customer bankruptcy filings." Sears asserted, however, that "the delinquency rate for 2001 remained relatively flat with 2000." In fact, as noted, Sears Card delinquencies had risen from 7.86% at the beginning of 2001 to 8.91% at year-end, a 13% increase. The Sears MasterCard also saw a 73% increase in delinquencies from the first quarter of 2001 (1.15%) to the fourth quarter (1.97%). (Id. ¶¶ 106-08.)

  On March 14, 2002, American Banker carried a story titled "A Catalog [of] Reasons for Sears' Card Profits," detailing the reasons for Sears' apparent success in the credit card business. The article observed that Sears had placed "a heavy emphasis on risk management" and reported that "Mr. Keleghan brags that Sears' portfolio nearly equals the market leader MBNA in its chargeoff rate." (Id. ¶ 109.) On March 28, 2002, the Chicago Sun-Times reported that Sears' credit cards accounted for 65% of its operating income in 2001 and was "a positive" for the company. According to the article, investors said that "[t]he income has provided Sears with the funds to improve stores and invest in new projects." (Id. ¶ 110.) On April 10, 2002, Sears issued a press release, filed with the SEC and signed by Mr. Bergmann, announcing preliminary earnings for the first quarter of 2002. The reported earnings exceeded Wall Street projections by more than 50%; Sears reported that operating earnings had increased 107% for the quarter due to cost-cutting measures in the retail segment and "a very strong quarter" in the Sears credit segment. As a result, Sears increased its earnings projections for 2002 from 13-15% growth to 17% growth over the prior year. (Id. ¶ 111.) On April 18, 2002, Sears issued another press release, filed on Form 8-K and signed by Mr. Liska, repeating these numbers and stating that the Credit and Financial Product division's operating income had increased by $78 million (21.4%) to $443 million.*fn9 In the press release, Sears acknowledged that the net charge-off rate had "increased to 5.43 percent from 5.07 percent last year primarily due to increased customer bankruptcy filings over the last year." The company reported a slight decrease in year-over-year delinquencies, however, from 7.50% in the first quarter of 2001 to 7.31% in the first quarter of 2002, "indicating stable portfolio quality." In addition, the company stated that "[t]he domestic allowance for uncollectible accounts of $1.1 billion is 4.13 percent of ending credit receivables compared with 4.14 percent at the end of last year's quarter." (Id. ¶ 112.) Unlike the April 10, 2002 press release, which described Sears as "a leading U.S. retailer of apparel, home and automotive products and services," the April 18 release described Sears as "a broadline retailer with significant service and credit businesses." (Id. ¶ 113.)

  Also on April 18, 2002, Sears held a conference call with analysts to discuss its first quarter results. During the call, Mr. Lacy reported a "record first quarter" for Sears and stated:
Our credit and financial products business had an outstanding quarter, with operating income growing by 21% on a comparable basis. This was the result of higher revenues and favorable funding costs. The Sears MasterCard product continues to be a valuable growth vehicle for us, with balances now over $6 billion. (Id. ¶ 114.) Mr. Lacy reiterated Sears' projection for a 17% increase in earnings for the year, which he deemed "conservative." (Id.) Mr. Liska acknowledged very poor performance in the retail segment but reported a "stable portfolio quality" with respect to Sears Credit:
For the quarter, credit and financial products revenue increased 1.4% to $1.3 billion primarily due to higher average balances. The allowance stands at $1.1 billion, or 5.13% of all receivables. In rate terms, this is flat with prior year and up slightly versus the end of 2001. The net charge-off rate increased by 36 basis points over last year to 5.43%, primarily the reflection of an uptick in bankruptcy filings. The 60 plus days delinquencies are down in the first quarter, approximately 20 basis points to 7.31% versus a year ago at 7.5%.
(Id. ¶ 115.) Mr. Liska qualified these statements by noting that the "current macro economic outlook remains uncertain at this point." He expressed optimism, however, as to Sears' ability to manage "any potential risk of a charge off line" and stated that the company was "cautiously optimistic that credit will do better than the mid-single digit increase guidance we previously communicated." (Id.) In response to an analyst's question about the adequacy of Sears' allowance for bad debt, Mr. Liska responded that "[w]e're very comfortable with the absolute level of that reserve." (Id. ¶ 116.)
  At the end of the main presentation, an analyst asked what Sears management "had said, or could say, about what Sears expected . . . its `loss experience to be with the MasterCard portfolio.'" (Id. ¶ 118.) Rather than providing information as to the separate MasterCard and Sears Card portfolios, Mr. Lacy and Mr. Liska both insisted that the portfolio needed to be viewed as a whole. According to Mr. Liska,
[W]e're approaching this on a portfolio basis, because as you probably know, we originally . . . substituted people out of the Sears card into the Sears MasterCard that were of better credit quality or had stopped using their Sears card. So, we look at it more as managing a portfolio and we're probably never going to be in that position that we're going to talk about them as discre[te] portfolios because we don't manage it like that. And it would probably be misleading if we did that. So, we're just going to comment on it on a total portfolio basis.
(Id. ¶ 119.) Mr. Lacy agreed with Mr. Liska and assured the analysts that Sears "started off . . . with the most pristine credits within the Sears proprietary card base" and "focused on those people that are very strong credit quality people." At the same time, he did state that "as we go forward, that's going to get more blended." (Id.)

  On May 7, 2002, Sears filed a Form 10-Q for the first quarter of 2002, signed by Mr. Bergmann and repeating the financial information contained in the Form 8-K. Sears misleadingly represented that delinquencies had decreased by "19 basis points" compared with the first quarter of 2001; that charge-offs had risen from 5.07% to 5.43% (a 7% increase); and that credit quality remained "stable." In fact, viewing the portfolios separately, charge-offs on the Sears MasterCard had increased by 230% from .80% in the first quarter of 2001 to 2.65% in the first quarter of 2002, and charge-offs on the Sears Card had increased 16.4% from 5.29% in the first quarter of 2001 to 6.16% in the first quarter of 2002. The Sears MasterCard had a delinquency rate of 2.55%, an increase of 122% (140 basis points) over the 1.15% reported in the first quarter of 2001. The Sears Card similarly saw a jump in delinquencies from 7.86% in the first quarter of 2001 to 8.77% in the first quarter of 2002, an increase of 11.6% (91 basis points). (Id. ¶ 121.)

  4. Second Quarter 2002

  On May 13, 2002, Sears announced that it was acquiring Lands' End, Inc., "the largest specialty apparel catalog company and seller of apparel on the Internet in the U.S." (Id. ¶ 123.) Mr. Lacy asserted that the transaction would not affect Sears' projection that 2002 full year comparable earnings per share would increase approximately 17% over the previous year. (Id.) In response to this announcement, Sears' stock price rose 9% in one week from $51.81 on May 10 to $56.46 on May 17. On May 14, 2002, UBS Warburg upgraded its rating on Sears to "Buy" from "Hold," and Standard & Poor ("S&P"), the rating agency service, "reaffirmed its `A-' rating on both Sears and SRAC debt." (Id. ¶¶ 124, 125.) The Lands' End acquisition was completed on June 17, 2002. Of the $1.6 billion raised in "these offerings,"*fn10 $629 million was directly backed by Sears' credit card receivables. (Id. ¶ 127.)

  On July 18, 2002, Sears issued a press release, filed with the SEC on Form 8-K and signed by Mr. Bergmann, reporting results for the second quarter of 2002. In the press release, Mr. Lacy is quoted as saying that Sears expected a 22% increase in full year comparable earnings (compared with the 17% increase projected in the first quarter of 2002). The press release indicated that "[t]he net charge-off rate for the quarter decreased to 5.32 percent from 5.42 percent last year primarily due to decreased customer bankruptcy filings." Sears also reported that yearover-year delinquencies decreased from 7.26% to 6.87%, "indicating stable portfolio quality," and that "[t]he domestic allowance for uncollectible accounts of $1.4 billion is 5.1 percent of ending credit receivables compared with 5.24 percent at the end of last quarter." Total operating income for the quarter was $666 million, $412 million of which came from Sears Credit. (Id. ¶ 130.)

  In addition to these figures, the July 18 press release also announced an accounting change:
The company announced a change in its accounting for the allowance for uncollectible accounts in the credit business. Sears historical allowance methodology provided for uncollectible principal and accrued finance charges on past due accounts. Sears has changed its allowance methodology to include current balances and accrued credit card fees in the methodology. The company believes that this change in its methodology moves it appropriately to a more conservative position in regard to its allowance for uncollectible accounts. As a result of the accounting change, the company recorded a cumulative effect, noncash charge of $191 million as of the beginning of the fiscal 2002 year. The change did not impact second quarter 2002 results.
(Id. ¶ 131.) According to the Complaint, "Sears admitted that until this point, it had entirely failed to create reserves for probable losses for accounts that were not delinquent, thus creating a false impression that its portfolio was larger and more profitable than was actually the case." (Id.) During a July 18, 2002 conference call with analysts, Mr. Lacy said that "[t]he credit quality of our receivables portfolio has . . . improved. Both our delinquency and the charge-off rates have improved versus last year." Mr. Lacy also assured investors that the new accounting methodology "is non-cash and does not imply any change in our portfolio credit quality or the economics of our credit business." (Id. ¶¶ 132, 133.) He concluded by reiterating Sears' projected 22% increase in earnings over the previous year. (Id. ¶ 134.) Mr. Liska then reinforced Mr. Lacy's comments, stating that the accounting change "has no economic impact and doesn't reflect any underlying change [in] portfolio quality. In fact, delinquency [and] net write-offs have both improved versus last year." (Id. ¶ 135.)
  During the conference call, an analyst asked Mr. Lacy about Sears' performance in comparison with that of Capital One, which had reported that bank regulators were requiring it to "increase its capitalization and reserves, and to tighten its risk controls in light of its significant proportion of loans to subprime consumers" (39.8% compared with the national average of 36.6%). Mr. Lacy stated:
In our case, we are about 180 degrees different than CapOne . . . You know, we have never intentionally lended [sic] to subprime people, people as they get into trouble do migrate to being subprime, but we never intentionally lent to subprime people . . . So, our growth, and I guess I would say perhaps in contrast to CapOne, our growth is being based on a payment product that is appealing to even better risk customers and therefore, as we grow, we are in fact improving the overall credit risk of our portfolio.
(Id. ¶¶ 129, 136.) At the end of the call, Mr. Liska assured investors that Sears had invested significantly in risk management and "fe[lt] very good about the systems environment." (Id. ¶ 139.)

  The market reacted favorably to Sears' statements about its second quarter 2002 performance; on July 18, 2002, Sears' stock closed at $45.75, up from $44.33 the previous day. In an analyst report dated July 18, 2002, Merrill Lynch stated that Sears "does not engage in any sub prime lending" and that "the Sears credit division debt/equity ratio is currently 9x, well below the typical 15x of traditional monoline credit card issuers." In another analyst report dated July 19, 2002, Banc One reported that "Sears does not lend to subprime customers, a segment that has attracted increased scrutiny given the problems at Capital One." (Id. ¶¶ 140, 141.)

  On July 22, 2002, the OCC, the Federal Reserve, the Federal Deposit Insurance Corporation ("FDIC"), and the Office of Thrift Supervision (together, the Federal Financial Institutions Examination Council ("FFIEC")) issued draft new guidelines on credit card lending, "[i]n part in reaction to the Capital One problems." (Id. ¶ 145.) The new guidelines provided, among other things, that (1) card issuers should carefully consider risk exposure both when increasing lines of credit and when issuing additional cards; (2) "workout" programs should not extend longer than 48 months; and (3) lenders should utilize proper risk controls to ensure that they have adequately reserved for losses. (Id.) Mr. Keleghan was asked about Sears' reaction to the new guidelines during an interview with Bloomberg News on July 25, 2002. Mr. Keleghan stated that "[f]rom everything I've read, I feel we're already there." With respect to the problems at Capital One, he assured investors that "I don't suspect we'll come under the same scrutiny. We don't do subprime lending at all in the MasterCard portfolio. All my growth is coming from prime and superprime." (Id. ¶ 146.) ...


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